The carry trade in yen continues to unwind
Posted by Matt Dioguardi on October 20th, 2007
As I write this it now takes 114.52 yen to purchase a dollar (link).
So let’s ask the question again, are people still unwinding those carry trades?
Japan’s currency also advanced as equity markets came under pressure. Analysts said the resulting rise in risk aversion was accompanied by investors trimming back carry trades. In the carry trade low-yielding currencies such as the yen are sold to finance the purchase of riskier but higher-yielding assets elsewhere. The yen rose 1.4 per cent to Y164.30 against the euro on the week, gained 1.4 per cent to Y235.90 against the pound and climbed more strongly against the high-yielding Australian and New Zealand dollars – 3 per cent to Y103.00 and 4.9 per cent to Y86.60 respectively. Worries that the G7 might take a more forthright stand over the weakness of the yen also gave the Japanese currency a boost, though most analysts thought such fears unfounded. (Financial Times)
Remember, that interest rates (such as those set by central banks) should be reflected already in the value of the currency. So what fuels the carry trade is mostly speculation. Right? So this creates a sort of bubble (though a small localized one), doesn’t it?
The issue is now being regarded as serious enough that the G7 is going to look in on it. I think it goes without saying that the primary reason for the weak yen in the past has been Bank of Japan interventions to keep the yen low (in order to help exports). Has the cheap yen at least playing a bit part in the sub-prime mortgage problems now unfolding in America?
Link:
October 21st, 2007 at 10:55 pm
I think it goes without saying that the primary reason for the weak yen in the past has been Bank of Japan interventions to keep the yen low (in order to help exports).
Where does the assertion that the BOJ has intervened come from?
Foreign currency reserves and operations are the domain of The Ministry of Finance, not the BOJ. The BOJ has no mechanism with which it can intervene in currency rate.
The Ministry of Finance publicly announced when it goes through yen-buying operations. The last time it did so was in March of 2004. The US Treasury Department has repeatedly stated that there is no evidence that Japan has intervened in the exchange rate since that time.
None aside from US politicians from Michigan (who need the votes) have made the assertion that Japan has intervened to keep the yen weak in the past three years. There is simply no evidence that it has happened.
Morgan Stanley’s Stephen Jen has blamed low interest rates for the weak yen, but again: not even a hint that the Japanese government has intervened: http://www.morganstanley.com/views/gef/index.html#anchor4705
The Bank of International Settlements, in its most recent annual report, said that the yen’s weakness was ‘abnormal,’ but never hinted that the MOF was intervening: http://www.bis.org/publ/arpdf/ar2007e.htm
I’d love to see evidence that the BOJ was somehow intervening in exchange rates when 1) It’s not their job to do so and 2) No one else is claiming it, and we haven’t seen their trades come up on the grid.
October 23rd, 2007 at 10:42 am
Ken,
I’ll go back and do my homework on this and make sure I understand who is responsible for what next time I post.
It’s my understanding that Japan’s interest rate have been very low, and that this is what fuels the carry trade.
When we say the interest rate is low in Japan, is it not the bank of Japan that is ultimately responsible for setting the rate (even if the Ministry of Finance has input into the policy)? I suppose I don’t understand this well, and need to go back and study the issue.
But so long as the interest rate in Japan is kept low, does this not discourage ownership of yen, as it cheapens the currency? The net result being people want to hold other currencies?
I guess I should not have used the word intervention as this could easily imply the buying up of American dollars to affect exchange rates. I don’t really think I had this in mind when I wrote the above.
I just have an intuitive idea I’m working on, and I haven’t had time to really review the literature to see if what I am thinking is correct.
It’s a bit like this. For any given product, if left to the market place the price of the product will tend towards a certain point dependent on the supply and demand for the product. However, if the government were to intervene and artificially set the price, this would probably cause unintended consequences. For example, if the price were too cheap, there would probably be a shortage of the product.
Money is at least a little similar. Interest rates are sort of like the price we pay to make use of someone else’s money for a certain amount of time. If left to the market place, then the use of another person’s money will tend towards a certain interest rate depending on the supply and demand for money. When we have the government through its policies either affect this this rate or even set it, then this is probably a distortion to the market and will lead to unintended consequences.
Why has the primary Japanese interest rate been so low for so long? Certainly one reason, among others, is to keep the value of the yen (artificially?) low. This fuels exports.
What I am curious about is whether or not there are unintended consequences for such a policy, and if so, what are those consequences?
Given that currency evaluations should reflect interest rates *already* how is that people think the carry trade will even work?
I am still new to this topic, and I still feel I have a lot of room to cover before I master the details, but I still think there is some merit to the point I was trying to make in the post above.
October 24th, 2007 at 1:38 pm
Certainly, there are many people who have tied low interest rates and a weak yen; some say there is a direct relationship, others indirect, there are some who claim a causal connection, some who say it’s psychological, and others who think the whole thing is bunk.
I think it’s part of a variety of factors that have led to a weak yen. Without a doubt, having low interest rates makes it appealing to borrow yen and use that as capital for investments. And, those who live in the nation would prefer to hold higher yielding currency. Both positions, however, depend on the currency’s rate either staying the same (which it can’t do), or further weakening (which history says is unlikely).
In late 2001/early 2002, the yen was at around 130 to the dollar with the 0.10% interest rate in effect. There was a weak yen and there were low interest rates, but no talk of a ‘carry trade’ at that time.
At any rate - I wrote a post on this a while back, but in 2004, Japan’s interest rates were at that same low level (0.10%), the MOF was intervening in the exchange rate until March, and what did the yen trade at that year? An average of 108.17451. The spread was 101.81 to 114.88. So, in 2004, we saw the yen hit 101.81 against the dollar, while the interest rates were supposedly so low as to prevent this strengthening from happening.
Today, we have (marginally) higher interest rates, but a weaker yen than in 2004. I don’t think the idea that there is a direct causal connection between low interest rates and a weak yen holds water. Looking at a historical chart of interest rates plotted versus exchange rates hints at no such connection. We need to bring other, more complex and difficult to measure factors into play.
Of course, times change, and perfect storms come and go. There are a lot of factors that have made the carry trade possible. I think the growing ease with which capital inflows and outflows can move around the globe has been a huge factor. It’s never been so easy to move money around. Japan has never seen anything like the ability to have the retail outflows it has now (ie, individual investors being able to buy and trade currencies, especially online). Couple that with the market moving in the ‘right’ direction, and more people become interested in buying foreign currencies. It’s a mix of being able to do some much more easily and it actually working as a strategy.
I think there are a lot of other factors behind this, and not much being written other than the interest rate/weak yen connection, when there is such a more nuanced story behind it. I think the tip of the iceberg has been scratched, but there’s a lot of digging to be done to really lay those factors on the table…wish I had the time!
October 25th, 2007 at 11:12 am
Ken,
I really appreciate your comments. I will take them into account when I post on this topic in the future.
Let me make some statements here. I will phrase them in as stark terms as possible, but despite this they are just opinions.
1. If the bank of Japan lowers the it’s target for the uncollateralized overnight call rate, this weakens the yen, without exception.
2. If the bank of Japan raises the it’s target for the uncollateralized overnight call rate, this strengthens the yen, without exception.
3. This does not mean other factors might affect the exchange rate such that changes in the prime rate will not always be reflected clearly in the exchange rate. There are obviously other factors involved.
4. It is a necessary prerequisite for the yen carry trade that interest rates be lower in Japan than they are elsewhere.
5. It is not a sufficient cause for the yen carry trade that interest rates be lower in Japan than they are elsewhere.
I appreciate the fact that you are bringing empirical data to the table here in an attempt to refute claims. I’m still new to this specific topic and am trying to go through a lot of information right now. While one shouldn’t ignore empirical data, I would find some claims still reasonable even if on immediate observation there appeared to be superficially conflicting empirical data.
For example, how about this claim, if prices go down people will buy more of a product. What if we went out and tested this and found empirical evidence that this didn’t happen in some cases. How would we respond? I think we would still say that the demand curve slopes down, but there were other factors involved.
This is, of course, really problematic because maybe we’re just using an evasive tactic to save a bad theory.
So the question of how to apply empirical data towards economic theories is clearly a hard one to settle.
For now, in the same sense I am willing to claim that the demand curve slopes down, I am willing to claim that when a central bank moves the interest rate it has a direct and unequivocal affect on the value of the currency.
My claim as far as the yen carry trade is far more shaky than any of the five claims I have stated above. I think it’s just speculation. I think policy making has been following certain trends and people are now thinking they can make reasonable guesses about future policy. I don’t think the carry trade should exist, and I think the severity of the problem is being under-evaluated in the press. One would hope that when the yen begins to appreciate, it does so at an even pace. However, given the likely large volume of carry trades, this is unlikely. Once the yen begins to appreciate (again), people will rush to get out the carry trade, and the yen will appreciate too fast. Also, there will be a rush to sell off all the investments people have made via their yen loans. So markets will tumble.
There are a variety of factors that could lead to this, and not only changes in the prime rate. We had a sampling of what can happen back in August, but I would guess things could get even more severe. I do not think the carry trade will continue indefinitely.
At some point, the yen will appreciate dramatically, and simultaneously there will be strong market corrections elsewhere. People can only defy gravity for so long. At least, these are my admittedly shaky predictions.
Monetary policy is the topic I’m most interested in right now, so I hope to have more to say about this in the future.
October 26th, 2007 at 11:37 am
1. If the bank of Japan lowers the it’s target for the uncollateralized overnight call rate, this weakens the yen, without exception.
2. If the bank of Japan raises the it’s target for the uncollateralized overnight call rate, this strengthens the yen, without exception.
I don’t actually see the connection between these two events. What time frame are we talking about? The 15 minutes of trading after the announcement? The first hour? One day of trading? Three days? A week? Two years?
The Bank’s changing the interest rates doesn’t actually do anything directly to the exchange rates. The psychology and decisions of those in the markets does. The exchange rates change based on agreements between buyers and sellers, which may be indirectly influenced by external news events.
October 29th, 2007 at 11:47 am
Ken,
Say you want to start a savings account. You are choosing between bank A and bank B.
Bank A offers a higher rate of return, so you choose bank A, right?
At least if you have no other information to go on. (Maybe bank B has a bad reputation, which is why they are having to offer a higher rate.)
There is a strong connection between the prime rate and the rate of return people get when they put their money in banks.
If the central bank increase the prime rate, I can then earn more future income with that bank’s currency merely by depositing it in a member bank. How can that fact not affect currency movements?
I’m just trying to point this out. I don’t think there’s any theory that’s not subjective on some level (as all theories rely on definitions) but the math here would seem fairly straightforward. It’s just a financial calculation. Rates go up, I get more money with this currency. Rates go down, I get less.
Whatever else is going on, and there’s a heck of a lot, any analysis has got to start at this point. You start with a calculation of expected future payments. Then you start factoring in all the other myriad of factors that might be involved. (Risk factors, possible future rate changes, long term economic outlook, financial stability and so on.)
Any analysis that is worth anything has to start with the basic numbers and calculate value that way. The prime rate is a fundamental number.
So long as there are no contravening factors, it would be hard to understand why a currency which pays more interest (albeit in the short term) would not be inherently more valuable than one that pays less.
So, while acknowledging there certainly are other factors, interest rates are really, really important when looking at exchange rates. They are the starting point for any analysis. (Though certainly not the ending point.)
How the central banks affect rates does affect a nation’s currency.
As far as the timing, I think people are constantly trying to figure out what central bankers are going to do. Right, now the Federal Reserve is already expected to lower rates next week. I think it’s much less clear what the BOJ will do this week. But I’m thinking the expectation might be that they will keep rates the same. (Not really sure though.) So to a large degree, these future changes are *already* being used to make financial calculations.