Liberal Japan

Yen Rallies Against Dollar, Euro

The dollar and the euro tumbled against the yen Tuesday afternoon as a drop in U.S. stock markets renewed investors’ risk aversion to bets on higher-yielding currencies funded by loans from Japan.

Reports pointing to falling U.S. consumer confidence and sharp declines in home prices, combined with more ratings downgrades on financial firms due to the credit market mess pushed the Dow Jones Industrial Average down 280 points Tuesday, most of the losses coming in a late-afternoon selling frenzy.

The shakedown in equities sent the dollar to an intra-day low of 114.25 yen, 1.6% lower on the day, and pushed the euro 1.8% lower against Japan’s currency, to a low of 155.48 yen. Other higher-yielding currencies involved in the carry trade, such as the Australian dollar, also took a hit.

In carry trades, investors borrow currencies such as the yen that offer low interest rates, then exchange them for higher-yielding assets that pay better returns. In times of market volatility, investors often pull out of these one-sided bets, worried that other investors will do the same.

Analysts said the yen’s gains show that investors had not completely exited their yen carry trade positions during market volatility earlier in the month, and said more unwinding is possible in the coming days.

“The yen is strengthening again,” said Michael Woolfolk, currency strategist at the Bank of New York Mellon. “There are concerns about the carry trades that still may be on the books.”

So the yen is getting stronger again. It seems to me the Fed is between a rock and a hard place. They don’t want to encourage rampant and abusive credit markets that over lend by trying to lower rates, but they don’t want America’s economy to spin out of control into a deep recession. No wonder they’re not doing anything right now, but watching.

The problem is over lending in the credit markets, again primarily though not exclusively in the subprime morgtage sector. What I find interesting is that the above report seems to be saying, “Oh, gee, there was some carry trade left over.”

It’s sort of like … yeah. The last time this happened, a couple of weeks ago, the markets were really overwhelmed:

The rapid unwinding of the carry trade in recent days strained the $2 trillion-a-day foreign-exchange market, usually among the most liquid of any market, even during crisis periods. But on Thursday and Friday, traders complained that at certain times, trading even small yen orders became a challenge because buyers were overwhelming sellers. Some traders said the prices offered them looked so odd they suspected that some banks weren’t really prepared to trade the currency at all. “They just don’t want to make prices,” one trader said. “They don’t know where prices are.” — WSJ

And you had people predicting the yen getting stronger:

Rodrigo Guimaraes, a Barclays currency analyst in London … says that three conditions are usually necessary for the carry trade to thrive: a funding currency with low interest rates, low market volatility and plenty of trading liquidity. Mr. Guimaraes figures Japanese rates will remain low for some time. But he thinks it may be a while before volatility eases and liquidity may not return to the abundant levels seen in recent years. Meanwhile, he sees further unwinding of the trade in the days ahead. “We think that long-term investors, such as corporates and Japanese individuals, are only just beginning to unwind their long carry positions,” he said in a recent report. While the dollar strengthened a bit on Friday to 114.21 from 113.88 yen, Mr. Guimaraes sees it going to at least 110 yen. — WSJ

Then, on August 17th the Fed’s discount rate was lowered, and Japan began pumping as much yen as they could into the market. Given these interventions they were able to sort of maintain the market. This basically calmed a lot of the investors, who then began to think they’d over reacted. Some probably even renewed their carry trades. Suddenly some analysts were actually saying the yen might get weaker by years end.

But there clearly was still a lot of carry trade left. One issue is time. A lot of transactions inevitably involve time deposits and so on where there is a stronger penalty for opting out of the trade early. So the longer the term of the carry trade transaction, the more resistance there is to want to opt out so as the avoid the penalty. However, it’s quite possible that even these people will start wanting to opt out once the writing is more clearly on the wall as to what is happening.

I think given the credit market situation in America, there’s not a lot the Fed or the Bank of Japan can do to save the yen from going towards 110. But who knows. If the situation is handled really poorly, the yen could even get stronger than 110.