COLUMN-Carry trade goes way of all leverage

By James Saft

LONDON (Reuters) - It was fun while it lasted, but the carry trade -- maybe the world's biggest leveraged bet -- is rapidly fading from the scene.

The practice of borrowing in currencies with low interest rates, like the Japanese yen or Swiss franc, and plonking the money into something with a higher rate, or something you just hope will go up, has been estimated at up to $1 trillion (500 billion pounds) in value.

But the great unwinding of debt now underway has made banks too scared to lend much and investors too scared to take on much risk.

Markets have become far more volatile in recent months, raising the risk of losing big money on carry trades, while declining interest rates in markets like the United States rob the trade of some of its potency.

"With lending conditions substantially tighter than last year there will be less of an appetite to fund carry trades," said Simon Derrick, head of currency research at Bank of New York Mellon in London.

"And if investors see less opportunities in high risk markets, (they) don't have to borrow as much."

The carry trade has clearly taken a big knock since financial markets became unstable last summer, as shown in a strengthening yen.

On a trade-weighted basis the yen had been declining since 2000, as investors, or speculators if you prefer, borrowed yen and then sold them to buy anything from New Zealand government bonds to real estate in Hawaii.

But since the summer the yen has strengthened -- some 13 percent against the dollar and substantially against others.

Like so many things now reversing, such as real estate investment, the carry trade was a self-fulfilling momentum trade that works beautifully -- until it doesn't.

Borrowing yen at a half a percent and buying New Zealand two-year bonds yielding more than seven percent is sweet, so long is the money is there to borrow and the yen doesn't strengthen, making your debt bigger.

The momentum has now reversed, and there are good reasons to think the unwinding of carry trades has further to go.

"The days of volatility gradually grinding lower are behind us," Ashley Davies of UBS in Singapore wrote in a note to clients.

"Leveraged carry trade activity will likely remain capped, since investment banks are taking a more cautious approach to managing capital in the aftermath of the subprime crisis."

WHERE HAVE YOU GONE, MRS WATANABE?