In late February there was a short-lived correction of the yen weakening trend as the financial markets ran into some overdue turbulence. Some investors chose to cover or reduce foreign exchange exposure as a result. However the rush to blame everything on the carry trade was hugely mistaken. World stock and bond markets had had a major run up and profit taking was inevitable. The yen and other low interest rate currencies temporarily strengthened and risk reversals blew out as uninformed ‘experts’ wrongly predicted massive loss cutting and liquidation of such trades. The pertinent questions are why and under what conditions would a wholesale unwinding occur? While clearly market volatility or rapid yen strengthening can never be ruled out, it seems hard to believe that the Achilles Heel of the world financial system is simply the carry trade.
Borrowing in a low yield currency and investing in a higher yielding asset has existed ever since major currencies were allowed to trade freely and whenever wide interest rate differentials opened up. Recently the risks of such trades and their ‘imminent unwinding’ have been greatly overstated by many commentators, as has the extent to which most hedge funds rely on this particular ‘anomaly’ to generate returns. The carry trade can indeed be hazardous to those without awareness of the risks. But for those with the skills to exploit it or a natural need for the ‘other’ currency it is a source of investment opportunities and alpha.
Is the widespread borrowing of the yen, Swiss franc, New Taiwanese dollar and even, synthetically, the Yuan really a portent of stock market crashes and hedge fund implosions? Most people, though sadly not all, now recognise the dangers of crowded, consensus ‘one-way bets’. The carry trade is indeed being employed by hedge funds and other investors globally. But most are aware of the risk and some have taken advantage of low volatility to hedge with options or in other ways. Some of this borrowing also has a non-trading basis and would be likely not to lead to massive unwinding even if those currencies significantly strengthened.
There are other reasons to short the yen than just because it has a poor yield. The yen has indeed fallen in recent years but considering that it has generally appreciated since 1971 we were perhaps overdue for a long term bout of yen weakness. In those 36 years (Fig 1), despite a lower interest rate most of the time, GBP/YEN has moved from over 800 to around 240 today. Japan has had near zero rates since the mid-1990s yet remained quite strong for much of the ‘lost decade’. The US dollar offers a higher yield yet USD/YEN has been mostly trendless (Fig 2). Only against other major currencies has the trend been clear (Fig 3). It would seem that the dollar has been as weak as the yen. With economic growth not as robust as elsewhere and inflation apparently under control there are good reasons to be bearish on the currencies of the two world’s largest economies. If it was solely due to interest rate differentials one would have expected the dollar to also appreciate against the yen but that has not been the case.
Who is making all this money out of carry? If the carry trade is so prevalent why has the performance of dedicated currency-focused hedge funds been relatively poor? I spend a lot of time on performance measurement, exposure attribution and identifying where a particular fund made its money and took risks, but rarely is the carry trade the dominant factor. Surely if yen carry trades were such a crucial performance driver, FX funds would be leading the track record tables not lagging. Of course many funds have profited from yen (and dollar) weakness but other hedge funds lost due to betting on yen (and dollar) strength. Many hedge funds make use of cheap yen leverage but it is an exposure most of them can manage. Some have reduced that particular risk because not only is the cost of carry low but also the cost of hedging the FX risk.
Differences of opinion fortify a market. Hedge funds have proliferated in sheer numbers, assets under management and range of strategies since the carry trade volatility of October 1998. The more hedge funds there are the less chance that the failure of one large fund can threaten the world financial system. As we saw with Amaranth last year, unwinding trades can benefit other hedge funds. Low volatility and high volumes in currency trading may reflect the liquidity of a vibrant two-way market. Some funds are long the yen while others have hedged their short exposure. Some have borrowed and outright shorted the yen for reasons other than carry. Dangers arise when positions are extremely skewed in one direction but this does not appear to be the case now.
A typical carry trade hedge is an options strategy called a risk reversal; buy a yen call and finance this by selling a yen put. This will profit if the yen suddenly rose strongly. When the recent ‘panic’ was at its height, risk reversals were bid as high as 2 volatility points in favour of yen calls. Sometimes quotes have been sufficiently low that interest rate spreads remain attractive even with this hedge in place. Selling borrowed yen and executing the risk reversal reduces the risk in a yield spread and can allow some participation if the yen weakens.
The Bank of Japan has raised rates to 0.50% and though some said this would impair or end the carry trade, spreads have actually widened with many non-Japanese interest rates rising faster. Currently there is a full 5% difference with GBP rates and even more in some other currencies like AUD and NZD. Even if you sacrifice 1-2% on the FX hedge with a risk reversal, the ‘arbitrage’ can still be there with such disparities in rates. Although there may be further cautious rate hikes in Japan over time, the differential will possibly remain attractive.
However not all this ‘enormous’ borrowing of yen gets converted into other currencies. There are domestic trades around. The yen bond, interest rate swaps and options markets are very inefficiently priced and therefore provide consistent alpha generation opportunities. Some hedge funds are leveraging in yen to arbitrage the Japanese fixed income markets and the positive yield curve. There is also plenty of borrowing by foreigners to invest in yen-denominated stocks, Japanese private equity and real estate. These trades may have risk but borrowing yen to trade yen-denominated securities obviously has zero FX exposure.
Globalisation of capital flows and investment opportunities has benefited investors in terms of portfolio diversification and yield enhancement. Many currencies in Eastern Europe, Latin America and elsewhere in Asia are now available. Numerous ’emerging’ equity, bond and real estate markets have long since emerged. It makes sense that the largest sources of investment capital (USA and Japan) would experience monetary outflows as investors take advantage of increased international opportunities. Many of those economies are booming and have favourable demographics. As a capital-rich but not natural resource-rich country, the fundamentals still favour money leaving the yen.
The biggest yen bears are NOT hedge funds. Japanese investors, both institutional and individual, used to be infamously biased towards domestic assets. While as a percentage of assets still small, there is now more interest in international diversification and seeking higher income and capital appreciation elsewhere. That means borrowed or ‘real money’ yen is sold to buy the non-yen asset. Walk down any main high street in Japanese cities and in every brokerage window, next to the Aussie Dollar money market fund, are marketing materials for international equity and bond funds. During the 1990s holding cash or domestic bonds was not such a bad trade. The yield was very low but due to deflationthe purchasing power of that money actually went up. Now Japanese are looking for higher yields and that can mean looking outside Japan.
Leverage is available to a lot more people than just hedge funds. Yen loans and yen-denominated mortgages are offered for legitimate business reasons or to purchase overseas assets. Some wealthier Japanese are looking at second homes all over South East Asia. Naturally this means they are borrowing yen and buying local currency. Last year in Bulgaria I encountered a Japanese tour group not there as tourists but as real estate investors looking for bargains. Later in my visit I met Hungarians and Czechs with Swiss franc mortgages. Many individuals round the world are taking advantage of low cost currencies. They may get hurt but most are aware of the FX risk and comfortable with it. People have become much more geographically mobile in terms of where and in what currency they borrow and where they invest.
The dollar and yen may have weakened because of international diversification by USA and Japan investors. These days, yen flows to anything from investing in pre-IPO Vietnamese equities to financing the purchase of off-plan Dubai real estate. The vast population cohort born from 1947 to 1949 in Japan is starting to retire. Many of them are healthy and wealthy and preparing to travel and spend. Some are taking out yen mortgages to fund overseas property purchases. In Hawaii recently a new Trump development of luxury condos sold out in minutes mostly to Japanese using yen loans. At least $12 trillion has been sitting in zero-interest bank and post office accounts in Japan but now better uses are starting to be made of such a large pool of capital.
Japan is the most indebted major country and the Japanese Government Bond market is the world’s largest so the monetary authorities have their own form of carry trade on and could be considered even a form of capital structure arbitrage; in this case the capital structure of Japan itself. The Japanese government is reluctant to see yen interest rates get much higher because of interest costs on its $8 trillion bond liabilities. At current rates, Japan already pays nearly $200 billion a year in sovereign debt servicing costs. With inflation not really an issue the yield differential looks set to remain or even widen. Maybe it suits the Japanese government for the yen to be weak with other policy choices much less palatable. It also cannot let the yen strengthen too much as this will jeopardise the nascent economic recovery and cause losses on its own carry trade of massive holdings of US treasuries and foreign exchange. So unlike in the 1990s, the interests of Japan are possibly similar to those who have the carry trade on.
Investors who ignore history are condemned to repeat it. The two examples where the yen carry trade did have a major influence on global markets occurred in 1997 and 1998. At that time the Japanese banking system was insolvent, deflation was rampant, foreign assets were being sold and the resultant yen repatriated. In 1997 Asian countries borrowed too much yen and in 1998 certain prominent macro hedge funds borrowed too much yen. Both ended in crisis and global volatility. The situation is very different now. The excesses of the bubble 1980s have worked through the Japanese economic system. Hedge funds employ less leverage and big currency bets are much rarer. Many investors other than hedge funds are making use of cheap yen. Most transactions do not have to be unwound or can be hedged. Prime brokers and banks have become a little more disciplined about how much and to whom they provide leverage. The increased sophistication and institutionalisation of the hedge fund industry has brought focus to risk-adjusted returns not just top line performance. The carry trade is just one source of alpha among many. And why would Japan stop lending yen now? Japan has lots of money and the economy is much more stable than ten years ago. The carry trade is not without risk but then nothing is.
Veryan Allen is CEO of Allen Investment Advisors in Tokyo. He blogs on hedge funds at http://hedgefund.blogspot.com