For years, the so-called “Mrs Watanabe” and her brigade of Japanese households sold the low-rate yen to buy higher interest-rate currencies, such as the Australian dollar. But with the U.S. Federal Reserve moving to end its easy money policy and “commodity currencies” such as the Aussie under pressure from lower rates and resource prices, the days of the carry trade could be drawing to a close.
“That [carry] trade works until it doesn’t. And the Fed has basically just said that’s not going to work anymore,” Goldman Sachs Asset Management partner Michael Swell told the Australian Financial Review.
Prior to the global financial crisis, yield-seeking Japanese investors sought currencies ranging from Brazilian real to New Zealand dollars to gain higher returns. With total savings of 1,500 trillion yen ($15.8 trillion) earning ultra-low returns at Japanese banks, Japanese households have been keen buyers of “uridashi” foreign currency bonds issued in Japan, with emerging markets such as Turkey receiving some $3.5 billion in uridashi flows in 2012.
The popularity of the yen carry trade among overseas investors led to an estimated US$1 trillion being invested by early 2007. The Fed’s zero interest rate policy fostered the carry trade, with hedge funds profiting from borrowing at low interest rates and speculating on higher-yield investments, including corporate bonds and emerging market debt.
Yet signs that the party is over for the carry trade have sparked fears of massive unwinding by global investors.
The Australian dollar climbed as high as US$1.10 in July 2011 partly as a result of the carry trade, but has recently fallen to as low as US$0.94 on the back of weakening commodity prices and interest rate cuts by the Reserve Bank of Australia.
Meanwhile, the Bank of Japan’s move to unleash aggressive monetary stimulus as part of Japanese Prime Minister Shinzo Abe’s reflationary Abenomics policies has sparked increased volatility for both the yen and Japanese bonds. Recent yen appreciation reportedly forced a scramble by Japanese investors to unwind the carry trade, with the effects felt around the world.
“Margin call”
According to UBS’ Art Cashin, the yen’s strength and recent dive into bear-market territory for the Nikkei Stock Average sparked major losses for US hedge funds, as noted by the Wall Street Journal:
“A couple of months back, when Mr Abe announced Abenomics (aggressive QE, purposeful increase in inflation, etc.), hedge fund wizards around the world flocked to what they saw as a “no-brainer” carry trade – short the yen (which QE should push lower) and buy the Nikkei (which would benefit from higher inflation and more trade from the lower yen). Scores of hedge fund managers reached for this too easy brass ring.
“Those are just one (most popular) of the carry trades. There are many others. And, when the yen spikes, it is like a margin call on each of those trades. We all painfully remember [what] forced liquidations looked like and felt like in late ’08 and early ’09. That’s what markets fear – possible random liquidations.”
Yet US hedge funds have not been the only ones to feel the pain. Recent volatility in the “commodity currencies” of Australia, Brazil and South Africa has been blamed on investors exiting their investments in such emerging markets, forcing spikes in bond yields.
“I am finding how much leverage the hedge fund community has. Everyone seems to be up to their earlobes in Mexican government debt,” Loomis Sayles co-head of fixed income, David Rolley, told the Australian Financial Review.
As the spread between higher and lower yield currencies has shrunk, leveraged traders have been squeezed on both sides amid the Fed’s threatened “tapering” of quantitative easing.
“With commodity prices under pressure and with growth slowing globally, there’s concern about the higher-yielding commodity currencies. The [carry trade’s] best days are behind it and it’s going to be much more of a trading market,” said Pierpont Securities strategist Robert Sinche.