No end in sight for yen carry craze

By Natsuko Waki

LONDON (Reuters) - High risk yen carry trades exploiting Japan's low interest rates are in no danger of losing their appeal as long as Japanese monetary policy remains predictable and financial market volatility stays low.

The BOJ raised rates to a decade high of 0.5 percent on Wednesday, saying it would tighten borrowing costs further but gradually.

Japan's rates are still the lowest in the industrialized world and the yen quickly erased initial gains to resume a broad decline, hitting a record low against the euro beyond 159.

Carry trades, where investors borrow in currencies with low interest rates and invest the proceeds in high yielding currencies, are seen by many as an unsustainable long-term strategy that can only thrive in a low-volatility environment with ample cheap money.

But investors seem eager to amass ever more yen-financed positions in higher yielding assets.

"We are again in a framework where carry trades work very well. As long as expectations of BOJ hikes remain moderate then shorting yen may be still in the market for some time," said Umberto Alvisi, currency strategist at Credit Suisse.

"There is fairly low volatility in the market. At a global macro level we are in an acceptable path of economic growth. It doesn't appear we have a big inflation or big growth issue."

Capital flows out of Japan have also contributed to the yen's weakness reflecting a structural shift in the behavior of domestic investors that is also likely to help keep the yen on a downward trend.

"There is a declining home bias -- investors are thinking they have to have a larger exposure overseas, some of which come in the form of carry trades," said Stephen Jen, chief currency economist at Morgan Stanley.

Morgan Stanley estimates there have been monthly outflows of around $2 billion by Japanese retail investors buying overseas "uridashi" bonds, issued in foreign currency terms. It also estimates outflows from investment trust funds denominated in foreign currencies total around $10-13 billion a month.

"These flows may not be cyclical, they can be structural," Jen said. "It can go on for quite a while until...the world turns round and realizes they have too little exposure to the Nikkei or other Japanese assets."

BOJ Governor Toshihiko Fukui said on Wednesday not all aspects of yen weakness could be described as the product of market distortion given the role of higher Japanese investment overseas.

WHAT SHOCKS?

The success of carry trades stems from low financial market volatility, especially in currencies, with investors exploiting a vast pool of liquidity put in place via steep interest rate cuts after the technology bubble burst in 2000 and Sept 11, 2001 attacks on the United States.

Policymakers have warned one-way bets in carry trades can be dangerous and that risks are under-priced. But analysts say markets have grown more robust, in part thanks to central banks.