FX: Carry on trading

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Is there an opportunity to initiate new positions at better levels or has the bubble burst?

Much has been made of the impact Japanese retail investors have had in dampening down volatility in the foreign exchange markets. For a long period of time, the strategy of selling yen and buying high-yielding currencies has proved popular and highly successful. The weight of the yen selling has confounded the expectations of many who have predicted that the US dollar would weaken against the yen. Supply and demand has ensured that this prospect has not materialized.

However, one impact of the global credit crunch that suddenly emerged through August was the huge and at times dramatic unwinding of carry trades. Opinion seems pretty well equally divided on the meaning of this: has the shake-out resulted in the market moving back to more attractive levels, or have things simply calmed briefly before a further storm materializes?

Carry on regardless

Spot $/¥ and one-month vol

Source: SuperDerivatives 

In a research note sent out on August 24 by its equity analysts, Credit Suisse argued that the yen carry trade is not over and that the unwinding is not "as problematic as some investors might believe". The bank argues that it is doubtful that the Bank of Japan will raise interest rates significantly this year, so the "abnormally high" interest rate differential with the US will be maintained. It adds that Japanese investors still have only a small proportion of their assets – just 2.9% – held overseas compared with 6% for US individuals. Credit Suisse also places great store on what the Bank of Japan would do if the yen did start to strengthen. "The BoJ could intervene to stop a dramatic rise in the yen, as they have done so often in the past. After all, over a third of growth has come from net exports," it argues.

It continues: "When some facts change, some opinions should change. Therefore, as risk premiums in the credit markets try to find a new equilibrium, some unwinding of yen-funded carry trades should naturally be part of the adjustment. Indeed, there is clear evidence of this. However, the fact of the matter is that it would be wrong to think that the yen carry trade is dead. The economics of the situation suggest that the yen will continue to be a source of liquidity."

Screeching halt

At the time of writing, this view seemed to be shared by many Japanese retail punters.

"These guys are more cautious and less leveraged, as their three-year uninterrupted profit streak came to a screeching halt. But they are at it again and have been profitable since August 18, although it will take a while for them to get back losses from August 17," says Drew Niv, chief executive of leading retail platform FXCM. "Remember that they took lumps in February too and came back strong as ever. It’s no different now and they are pumping in a lot more money as usual. It’s like yen crosses are on sale now as far as they are concerned. Yields are still as juicy as ever; that has not changed."

The return of aversion

However, some participants in the interbank market are extremely worried that too many "safe" one-way bets are being placed. In a note sent out to clients on August 29, Derek Halpenny, senior currency economist at Bank of Tokyo-Mitsubishi UFJ in London, warned: "The return of risk aversion to the financial markets has resulted in an upturn in volatility levels for the yen, which will further undermine the prospects of any near-term end to the current bout of yen appreciation."

Halpenny added: "There looks to be good support in USD/JPY below 114.00 with Japanese life insurers and Asian names buying dollars. USD/JPY positioning has certainly become more balanced and short-term market participants may already be running yen long positions. Nonetheless, USD/JPY downside risks due to renewed market turmoil remain significant."

In a follow-up call, Halpenny pointed out that what he considers vital reasons for the initiation of yen carry trades no longer exist. "The two key elements for a carry trade position are low volatility and a certainty in funding. These are not there at the moment. Vol levels are significantly above where they have been for the past six months and that’s not the environment for putting on carry trades."

There is also a growing unease that the popularity of structured products designed to deliver an enhanced yield to Japanese investors – specifically power reverse dual currency structures – will see a market caught in a vicious spiral of dumping dollars and buying volatility should the USD/JPY fall significantly. If this happens, it will be a case of history repeating itself.

History lesson

A similar event occurred in 1998 when the yen’s sudden appreciation from 145 to 112 against the dollar wiped out the Japanese dual-currency bond market. However, this did not deter the subsequent creation and marketing of more complex structures designed to deliver an enhanced yield. Power reverse dual currency (PRDC) bonds have been sold with maturities out as far as 30 years. One bank salesman sent a note to clients explaining the potential threat. "At one point, in the 2001 to 2003 period, the market for PRDCs was so large that many thought that the FX option risk associated with PRDC issuance would severely hurt the bank capital involved if JPY moved below 100. I don’t think it’s too terribly different now."

As the market moved tentatively into September, many seasoned traders remained extremely wary about what would happen if USD/JPY did start to move lower. Although carry trades might still prove fruitful, for the moment they look extremely dubious on a risk/reward basis.