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Carry Trade Ripples

Clifford Bennett - March 2007

Financial markets had a bit of a shake-up a week ago as equity markets experienced some panic profit taking and the Yen strengthened dramatically. To be honest it is too early to say that either market price shift has fully run its course, but the fact that the two have been frequently linked in the media means that developments in one are more likely to impact the other over the next few weeks.

The main focus here is the Yen carry trade story and its impact on other currencies - especially the Australian dollar - but a brief comment on equity markets is worthwhile because any further fall will create significant volatility in currency markets.

The equity market fall was ignited by China. It is interesting how the world has changed so much that the China market can now drive Europe and the US, for a couple of days at least. The truth is that any market that is severely overbought, as was the case for equities globally, becomes increasingly vulnerable to any unexpected catalyst that suggests a less bullish posture may suddenly be appropriate. So it was really the combination of an overly confident and long equity market, with the Chinese news catalyst, that triggered the sell-off. When markets correct they can often do so in a three wave pattern, meaning there is the initial sell down, followed by a bounce as some confidence returns, but this can also be the product of people not being prepared to sell their stocks at what seem to be unreasonably low levels.

As the market moves a little higher however, some of those still long start to think taking profits on this bounce may be a prudent idea. Once these relatively patient sellers start to push the market down again, others panic that the previous sell off is happening all over again, and they generate a self fulfilling decline, usually to a new low. Equity markets around the world run the risk for another week or two, of just such a fall.

For currency markets the implications are significant. What happened a week ago is that the decline in equity markets was enough of a shock to traders and investors generally, that they also immediately reassessed other aspects of their portfolios. The market that stands out as being of a historically unusual level of allocation is the so called “Yen carry trade”. The “carry trade” is simply borrowing in a low interest rate currency such as the Yen or Swiss Franc, and depositing those funds in a high interest rate currency such as the Australian or New Zealand dollars. If you borrow at 0.5% and deposit at 7%, it is not hard to work out that you are making money out of thin air, a very attractive proposition indeed. There is always a risk of course (as Australian Swiss Franc borrowers in the 1980s discovered, but that is another story), and it is the movement in the value of the currencies involved. Confidence has been building in the “Yen carry trade” for over a year now as the process itself has been reinforcing the attraction.

In effect participants do not need to actually borrow funds in Japan, all they need do is sell Yen and buy Australian dollars, and this can be done on margin which means leverage. So what we have today are large and small investors alike with highly leveraged massive short Yen positions, and bought/long a variety of other currencies with high interest rates. If the currency markets begin to move against them, Yen strengthens and the other weakens, they need to quickly exit their positions or risk losing not only the interest rate differential advantage, but also their margin investments.

As a result of this constant build up of “Yen carry trade positions” over the last year we have a situation now where the Yen is the most potentially explosive market in the world, and the effects of this market imbalance influence all global currencies, but especially the high interest rate currencies such as the Australian and New Zealand dollars. We have already seen how quickly these currencies will be marked lower by global markets at the first sign of any Yen carry trade unwinding. This is the most significant vulnerability of these currencies, and this factor far outweighs any domestic economic or political developments in the near term.

We have also seen how these currencies, the AUD and NZD, can bounce back relatively quickly once the dust settles on a Yen carry trade shake out. This is because the global investment community really does remain “yield seeking” at its core. Even though equity markets have had a very good run over the last year, the previous years of relatively low interest rate settings globally have lead to a degree of focus on any currency that provides a good above average yield, such as the AUD and NZD do. These currencies have other advantages as well. The Australian dollar enjoys an enormous degree of recognition as a “commodity” currency. As Australia sits on the doorstep of Asia in the midst of an ever expanding economic boom, our commodities are likely to remain in great demand for many years to come. Global investors see buying the Australian dollar as a double win – high interest rate and as an investment in Asian economic growth. The New Zealand dollar is increasingly recognized as a diversification and perhaps even safe haven vehicle, due to its geographic location and potential for “pure” products and even carbon credits.

What we have recently seen in these currencies in terms of price action is likely to be repeated quite often over the next several months or years. The occasional “Yen carry trade” unwinding scare will see the AUD and NZD quickly marked lower, only for these currencies to then renew their relentless, in a big picture sense, march higher. In an environment of a weakening US dollar these down under currencies, the Australian and New Zealand dollars, with their high yields and unique positioning, will remain a valuable component of global portfolios for many years to come.

In fact the Australian dollar could once again attain parity with the US dollar, $1.00, within a few years. This is not a far fetched call. The Australian dollar was in 1972 worth US$1.49, and it fell to just 48 cents. The Australian dollar is the “dollar that lost a dollar”, but now it is on the rebound in a very real and profound sense. While China and Asia grow, and that will not be stopping any time soon, the Australian dollar will steadily advance. Yen carry trade sell-offs of the Australian dollar are simply opportunities to buy.

Clifford Bennett is the founder and chief economist of independent research firm FxMax - ranked the “most accurate currency forecaster worldwide” by Bloomberg News in 2006. Clifford started his career at Macquarie Bank and was Senior FX Strategist Asia for BNP Paribas, based in Singapore, and a member of the BNP Paribas global economics group. He is the author of “Warrior Trading”.