Carry trade unwinding roils currency markets
***Rogue comment......Slider,where you and your boys buying the Yen to squeeze the specs??? The timing of your return here is highly suspicious!.....LOL!!****
Carry trade unwinding roils currency markets
12:28p ET February 27, 2007 (Marketwatch)
NEW YORK (MarketWatch) -- A sharp rally in the yen and the Swiss franc on Tuesday serves as a reminder of the risk of a massive unwinding of carry trade positions.
Carry trade refers to the practice of speculators borrowing or selling the yen or the Swiss franc at low costs and reinvesting in higher-yielding currencies and assets elsewhere, such as the New Zealand dollar, the British pound and the South African rand.
The yen climbed almost 1.7% against the dollar, the euro and the British pound on Tuesday. Against the Australian dollar and the New Zealand dollar, the Japanese currency surged 1.8% and 2.5%. Interest rates in Australia and New Zealand are among the highest among major economies.
Meanwhile, emerging-market currencies slumped Tuesday with the Turkish lira off almost 2%, the South African rand down 1.6% and the Brazilian real 1.4% lower versus the U.S. dollar.
The notorious carry trade has pushed the yen to a two-decade low on a trade-weighted basis early this year. Japan's low interest rates, which now stand at 0.5% and are the lowest among all major economies, have made the yen a popular funding currency.
The almost-free borrowing costs of the yen have also been responsible for financing massive bets in a variety of high-risk markets such as commodities and emerging markets. The carry trade is expected to be reversed as the Japanese economy strengthens and prices begin to rise.
The unwinding begins
Investors' risk appetite fell sharply in recent sessions on fears of the potential knock-on impact from subprime lending market woes and worries over Iran's nuclear plans. An almost 10% slump in Chinese shares overnight also encouraged traders to further unwind carry trade positions.
"Today, the most important issue in the currency market seems to be that traders and investors have borrowed huge amounts of yen to fund higher risk positions. And hence, if these riskier assets are suddenly thought to be too risky, the yen is back in demand," said David Brown, an analyst at Bear Stearns.
"A number of issues, such as Iranian tensions, the weakness in the U.S. subprime mortgage market and, most recently, a slump in Chinese shares all seem to have increased risk aversion," he said.
There are no official statistics on the size of the carry trade. But some economists estimate the total size could range from $200 billion to as high as $1 trillion.
The massive build-up of carry trades in recent years has led officials and economists to worry that a sharp reversal of these positions would have significant negative impact on financial markets.
Rodrigo Rato, head of the International Monetary Fund, warned on Tuesday that carry trades "could lead to more entrenched exchange rate misalignments that worsen global imbalances."
Rato also said that while the size of carry trades was unknown, there was no "simple solution" to the problem. He warned that financial markets and countries would be exposed if there was a sudden unwinding of financial flows.
G-7 warns of risk
Meanwhile, at the meeting of Group of Seven finance ministers and central bankers earlier this month, European Central Bank President Jean-Claude Trichet warned about the risks of carry trades, stating that "we want the markets to be aware of the risks in one-way bets, particularly on the foreign exchange market.' The official G7 communiqué didn't make any specific reference to weak yen.
Stephen Lewis, an analyst at Insinger de Beaufort, said "it's far from clear to what extent markets are taking it for granted that a weak yen, with low yen interest rates, will persist indefinitely."
"If investors noted merely a tendency on the yen's part to appreciate, they might well rush to exit from investments supported by yen borrowings," he said, in a note.
But Jay Bryson, global economist at Wachovia Economics Group, said some data sources have consistently showed that the yen carry trade probably "is not as prevalent today as it was in the late '90s when it was in full swing."
"This finding is consistent with anecdotal evidence that hedge funds are less leveraged today than they were in 1998," he said, in a recent note. "Therefore, the implication is that the global financial system may not be as vulnerable to a sudden unwinding of yen carry trades as some commentators predict."
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