Does c.bank predictability encourage carry trades?
Monday, February 19, 2007 1:00:09 AM (GMT-06:00)
Provided by: Reuters News
By Krista Hughes
FRANKFURT, Feb 16 (Reuters) - Group of Seven central bankers recently urged investors not to make risky one-way currency bets. Ironically central banks may themselves be at least partly to blame for the practices they want to discourage -- so-called carry trades.
Predictable interest rate policy has driven away much of the the volatility that speculators usually profit from and made the carry trade, where investors borrow in low-interest currencies such as the yen to make big returns elsewhere, irresistible.
In periods of low financial market volatility, investors are much more inclined to +seek higher returns from riskier assets and hold these positions for longer because the perceived chances of adverse prices swings are lower.
In the fixed income sphere, that means funding investments in high yielding securities by borrowing in cheap currencies.
The trend has been driven by Japanese interest rates staying so low for so long, while interest rates elsewhere have moved higher, for example in the United States and in Europe, or were at high levels anyway.
"If I make monetary policy predictable, I shouldn't be surprised if investors rely on it," German Bundesbank board member Edgar Meister said in a newspaper interview this week.
Barclays Capital economist Thorsten Polleit described carry trades as a "natural phenomenon" in a world where central banks fix interest rates and most major currencies float freely.
"By being explicit about the future path of interest rates you induce carry trades, to exploit the interest rate differential and the reduced uncertainty."
The use of the yen to fund carry trades has ballooned because Japan interest rates remained anchored close to zero over the past few years while other central banks around the world started lifting their rates.
Rapid Japanese growth at the end of 2006 has fanned expectations the Bank of Japan might raise rates next week to 0.5 percent from 0.25 percent. This helped lift the yen against the dollar and euro.
But even if the Bank of Japan does raise rates, analysts do not expect the carry trade to fall out of fashion because the catch-up distance on interest rates versus other major regions is huge.
Key policy rates in the United States and Britain are at 5.25 percent. Australia's is 6.25 pct, New Zealand's 7.25 percent, Turkey's 17.5 percent and the euro zone's 3.5 percent.
"I don't think that Japan can ever hike enough to stop carry trades," said Joerg Isselmann, a currency strategist at Germany's BHF Bank.
NOT JUST RATES
Still, the endurance of carry trades is not just down to central bank behaviour, foreign exchange experts say.
"Sterling-yen is one of the most popular carry trades and you can't accuse the Bank of England of being predictable," said Derek Halpenny, currency economist at BTM-UFJ.
The flow of funds from Japan into other countries is driven by a range of factors including large amounts of liquidity on global markets and a growing risk appetite among Japanese retail investors.
"In Japan you have small clubs of housewives trading currencies on mobile phones. The carry trade has gone crazy here," Morgan Stanley FX strategist Stephen Jen said from Tokyo.
Low volatility on global FX markets, which turn over more than $2 trillion a day, is a key driver of carry trades as it reduces traders' other options for turning a quick profit.
"Without volatility it's become more and more difficult to take a currency position based on a view of it going up or down," said Halpenny.
"Therefore looking at yield differentials and carry trades in that environment is a more attractive option."
Implied volatility on currency options, which measures the range investors think a currency will trade in over a given period of time, has fallen to record lows in recent months.
At the same time, traders have amassed record bets against the yen. Positioning data from the International Monetary Market on the Chicago futures exchange showed a record short yen position worth almost $18 billion, according to Reuters calculations, in the week ending Jan. 30, although they have come back since.
NO REAL CONCERN?
Strategists might get an answer soon to the question of whether central bank predictability drives the carry trade, as central banks become more unpredictable once their rates peak.
The U.S. Federal Reserve reached the end of its tightening cycle in June 2006, and many analysts forecast the ECB will reach the same point by June 2007.
"Will yen carry trades be compromised? I'm not sure. They will be if volatility increases to reflect this uncertainty," said Morgan Stanley's Jen.
"In theory it should, but in practice I'm not so sure."
Still, even if higher Japanese rates rise crimp currency speculators' style, Jen said carry trades were a fairly minor concern for the global economy.
"Yen carry trades could be seen as a slightly negative side effect from policymakers attempts to try to prevent bigger and more important events from blowing up," he said.
(Additional reporting by Jamie McGeever in London)
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