Credit concerns put carry trades on shaky ground

By Lucia Mutikani - Analysis

NEW YORK (Reuters) - Tightening credit markets and rising asset volatility from the U.S. subprime mortgage crisis may drive aggressive dumping of carry trades in 2008, with investors instead favoring safe-haven yen.

Most investors expect the credit crisis to keep a lid on risk appetite next year, suggesting carry trades will be dethroned as the dominant strategy in the $2-trillion-a-day foreign exchange market for the first time in more than a decade.

"When you have carry trade liquidation it is very often triggered by asset volatility and what we are seeing in the financial markets does speak against carry trades," said Hans Redeker, head of currency strategy at BNP Paribas in London.

Capital market spreads have widened since November, while Libor rates have remained elevated as the credit turmoil has forced financial institutions into mortgage-related write-downs worth billions of dollars.

For years, the pre-eminent form of carry trade has been for investors to raise funds in such currencies as Switzerland's franc and, in particular, Japan's yen, which sports the lowest benchmark interest rate in the developed world.

They then took that cash and bought assets in currencies from countries offering higher yields, pocketing the difference as profit.

Massive unwinding of these positions would boost the franc and more so the yen as potential losses force speculative hedge funds to cut other market bets and possibly reverse the flood of domestic Japanese money invested overseas in recent years.

BNP Paribas sees USD/YEN down to 98 by the end of 2008 from around 111.19 now.

Carry trades tend to thrive in periods of low volatility, steady economic growth and high availability of funds. In the last few years they have corrected and then recovered swiftly.

"When you look at the things that drove carry trades, they don't seem to be there -- very low volatility and very high availability of funds to use to fund the carry trade position," said John Noyce, technical strategist at Citigroup in London.

TREND REVERSAL EMERGING

Carry trade strategies dominated in the first half of 2007 and soon after the Federal Reserve's 50-basis-point interest rate cut in mid-September. But a reversal in trend has emerged in the last month, analysts say.

In November the dollar fell 3.6 percent against the yen, only the second time this year that it has fallen more than 3 percent against the Japanese currency in one month.

Another factor that could put carry trades and therefore high-yielding currencies out of vogue is the steepening U.S. Treasury yield curve.

"The second important variable for the carry trade has been the slope of yield curves in Western markets," said Hans Redeker, head of currency strategy at BNP Paribas in London.