Yen shock may prompt next wave of market crisis

By Mike Dolan - Analysis

LONDON (Reuters) - Just as renewed waves of forced asset sales and bank write-downs risk turning this year's credit market turmoil into a vicious circle, the Japanese yen looks set to deliver another shock to global markets.

An accelerating slide in the U.S. dollar .DXY this week has been driven by a growing conviction that the U.S. Federal Reserve will be forced into further steep interest rate cuts.

And as dollar losses against the yen started to spiral on Friday, fears have risen of a mass unwinding of the yen "carry trade" -- currency trades funded by cheap, low interest rate yen and estimated to be worth up to $200 billion.

Sudden losses on these trades -- which thrive when currency market volatility is low -- could force speculative hedge funds to cut other market bets to fund those losses, and also reverse the flood of Japanese money invested overseas in recent years.

"The potential for a further carry unwind -- presuming we are now in a second wave of risk aversion -- is quite high now," said Michael Metcalfe, senior strategist at State Street.

"These waves of risk aversion are washing through markets one after the other and seem to be hitting the credit markets first, then equity markets and then the FX markets," added Metcalfe. "It's what happened in July and August and it seems to be what's happening again now."

THREE INJECTIONS

The global financial system supercharged historically low central bank interest rates in recent years in several ways but there were three powerful injections.

One was through repackaging bank loans into securities for sale to a wide range of investors, freeing up bank balance sheets to allow them to lend more. Those markets are now in meltdown after a U.S. mortgage market bust called into question valuations of these complex instruments.

The second was via leveraged buyouts by the likes of private equity firms, who used cheap credit to raise cash and pumped billions into stock markets via a wave of takeovers. The credit squeeze has put much of this activity on ice.

And the third amplifier was currency carry trades, with cheap yen financing at its core.

Now that too looks at risk.

ECHOES OF 1998?

The dollar set successive historic lows against the euro and 26-year lows against the British pound earlier this week.

But on Friday it lurched to an 18-month trough against the yen of 110.52 yen, breaking the stable 5-yen range it had held since the Fed discount rate cut in August reversed a flight from risky currency bets.