Understanding the Yen Carry-Trade

[fabijo]

Unfortunately, there was NOTHING said anywhere here in 2006 about the practice of Carry-Trading with the sole exception of the term used in a former active members posts.

Bummer. Perhaps we could have been warned a little sooner. Robo's highly informative posts didn't have a hit on this keyword search before 2007.

Perhaps I'm not searching this MB correctly.

I'm just disappointed there was no warning about Carry-Trading and its possible affect on our markets. We need to educate ourselves on this and find a way to monitor it; as we monitor our funds, VIX, OEX etc...

Screw us once; shame on you carry-traders.
TWICE; ______________________________.

5T -

I remember reading about it a few times last year from people who posted on these boards. Here is an article that Ichiro posted about this time last year:

http://www.tsptalk.com/mb/showthread.php?p=38734#post38734

What's described in that article sounds a lot like what has happened this past week.

I did the search "yen carry"

 

[Fivetears]

Thanx fabijo, I figured I was keyword searching the wrong way. I find it very interesting that something that kills the US markets THIS BAD with such obvious and increasing regularity has gotten so little meaningful press and trader warnings in this MB. We watch trend lines, puts & calls, DowTransports, etc etc, all year and every day to catch a couple percent days here and there all year. Why haven't we been watching Japans Godzilla (Carry-Trade) from stomping 3, 5, 7, 10 percent from our treasured TSP accounts?

We just need to work together on this; for the next attack.

5T -

I remember reading about it a few times last year from people who posted on these boards. Here is an article that Ichiro posted about this time last year:

http://www.tsptalk.com/mb/showthread.php?p=38734#post38734

What's described in that article sounds a lot like what has happened this past week.

I did the search "yen carry"

 

[Fivetears]

http://www.tsptalk.com/mb/showthread.php?p=38734#post38734
Ichiro posts this information 28 February; 71 days before the 2006 "correction."
This topic has gotten very little discussion in comparison to the damage it causes. IMHO... this Godzilla needs to be watched from now on. I just want to learn & know how. At what point does this damn lizard break its chains, so we can all be ready next time. Countries giving away their currency at ZERO to very low interest rates need to be identified, and tracked for adverse lending conditions that result in carry trade induced collapse.

Market correction my fat ____ ____!

 

[350zCommTech]

I posted this on 2/3/07 in my 350z I fund thread. I got no questions about.

http://www.tsptalk.com/mb/showthread.php?t=3930&page=5

Yen carry trade explained:

"The Mechanics of the Carry Trade

With short-term Japanese interest rate remaining close to zero percent, the financial press is filled with stories of how the so-called "yen carry trade" is helping to fuel run-ups in the prices of many financial assets. The yen carry trade works this way: an investor borrows Japanese yen at very low interest rates. He then sells the yen and buys another currency - say, U.S. dollars. The dollars are used to buy a high-yielding U.S. asset - say, a non-investment-grade corporate bond. After the bond matures, the investor collects his principal and interest and sells the dollars for yen, which he subsequently uses to repay his original yen loan. In sum, the investor has borrowed yen at a low interest rate and has used them to buy a high-yield U.S. corporate bond. The same strategy can be employed to buy other high-yielding assets, such as Brazilian bonds, Hong Kong stocks, etc.

The upside to these trades is that investors can realize significant returns by borrowing low and lending high. The downside is that they can become unprofitable if short-term Japanese interest rates rise, which increases borrowing costs, and/or the yen appreciates. In the event of yen appreciation, the investor would need to sell more foreign currency than he originally anticipated to purchase the same amount of yen. Although yield differentials could continue to exist, the profitability of the trade could get wiped out if the yen appreciates too much.

Indeed, an unwinding of yen carry trades contributed to volatility in financial markets in October 1998. As shown in Exhibit 1, the Japanese yen, which had been depreciating versus the dollar for three years, began to appreciate in August 1998. In early October, jittery investors unwound their yen carry trades en masse by selling their high-yielding assets and the underlying currencies for yen to retire their yen obligations. Not only did the Japanese currency appreciate very sharply in early October as investors scrambled to buy yen, but prices of high-yielding assets tanked. The Federal Reserve cut the Fed funds rate twice (for a total of 50 bps) in the subsequent month to bring liquidity back to financial markets. Thus, the existence of a significant amount of carry trades is more than just an academic curiosity. They can potentially lead to significant amounts of financial market volatility if they are unwound at the same time."

http://www.actionforex.com/forex_an...sis_reports/yen_carry_trade:_fact_or_fiction?

 

[Fivetears]

We've had two Carry-Trade induced market "corrections" in a row now; possibly others. No questions asked about it is my point. Two in a row have occured now. You have my (as well as many others) undivided attention. How do we identify & dodge it next time, 350Z? People preaching gloom and doom simply wont do. We need numbers, charts, instruments / tools to monitor this.

I made numerous post mentioning the Yen carry trade in my 350Z I fund thread. The latest were on 2/10, 2/20 and 2/27, the day it started. I don't remember getting any questions about it on those days. I might have mentioned it a few times also in the "Playing the I fund thread". I don't remember though. I didn't become a member until late October.

 

[350zCommTech]

Fivetears,

I knew about the carry trade problem and I was the one who posted the graph of the Shanghai index 1 week prior to the 9% correction. What I didn't know was the EXACT date the correction was going to take place and did anybody knew that Greenspan was going to say what he said?

Btw, I also lose a bunch last week.

 

[Fivetears]

This sure seems like the type of information that can be tracked; used to guard TSP Talk Members for the next round. What else do we need to watch for?

The upside to these trades is that investors can realize significant returns by borrowing low and lending high. The downside is that they can become unprofitable if short-term Japanese interest rates rise, which increases borrowing costs, and/or the yen appreciates. In the event of yen appreciation, the investor would need to sell more foreign currency than he originally anticipated to purchase the same amount of yen. Although yield differentials could continue to exist, the profitability of the trade could get wiped out if the yen appreciates too much.

 

[Fivetears]

The information you posted deserved much more attention, IMHO. I'm part of the guilty party not listening then, and have lost several thousand as a result. This isn't a necessary market "Correction." It's carry trade collapse. You saw it coming, and I (we) didn't listen. The TSP Talk Team can do better than this, and you and I both know it.

Fivetears,

I knew about the carry trade problem and I was the one who posted the graph of the Shanghai index 1 week prior to the 9% correction. What I didn't know was the EXACT date the correction was going to take place and did anybody knew that Greenspan was going to say what he said?

Btw, I also lose a bunch last week.

 

[350zCommTech]

How do we identify & dodge it next time, 350Z? People preaching gloom and doom simply wont do. We need numbers, charts, instruments / tools to monitor this.

I don't know if there's a way to avoid being hit by it, aside from sitting out for an extended period of time. All we can do is recognize that it's happening and move out of it's way with minimal damage. The problems with carry trades is that I don't think they just unwind for no reason. It takes emerging market corrections, crisis, war, economic meltdowns, etc.. What we can do is keep an eye on currency/interest rate differentials and recognize which ones are being used.

Another thing that one should understand is that we are still in the early stages of the unwinding of the Yen carry trade. If things start to improve in the US and the USD/YEN continues to rebound(like tonight), then this bull market might continue. But if our economy is heading down as Greenspan suggested, the Yen will continue to appreciate causing more unwinding of the carry trade. Fear has a lot to do with.

 

[Spaf]

350Z,

It wasen't the Shanghai index or Greenspan. the Market needed to correct. What you heard was the media pundits excuse. The fundamentals are OK, so it's a correction, stay the course. Don't sell low or buy high, keep your strategy (risk vs reward) in play. Now it's a matter of patience!

Regards
Spaf

 

[fabijo]

It's a tough call on what elements play what. Combining the need for a correction with the rise of the Yen with the Shanghai vertical climb with Greenspan's words with taking profits, etc... all add together.

I agree that we need a better way to guesstimate the odds of a cheap loan unwinding. Probably the best way to do it would be to see which central banks have cheap loans along with how inexpensive their currency is. If it looks like their currency is rising up fast - maybe breaking resistance - we need to pay attention.

 

[350zCommTech]

Watch my Market Talk. This is a correction! I play it a bit differently being retired. Plan to CK socks in the AM and maybe trade over to [IVV]. Thats the reason I'm about 60% TSP, 40% online brokers.

350Z,

It wasen't the Shanghai index or Greenspan. the Market needed to correct. What you heard was the media pundits excuse. The fundamentals are OK, so it's a correction, stay the course. Don't sell low or buy high, keep your strategy (risk vs reward) in play. Now it's a matter of patience!

Regards
Spaf

True the market needed to correct, but this is not a normal correction. And yes, I know full well about the idiots on CNBC and CNNmoney. These people are also the ones telling you the fundamentals are OK. I don't think they are. Have you notice that all the Fed folks are telling us that everything is OK? I know..I know..What else can they say? But take last Wednesday for example, we had all kinds of bad news that day. PMI well below 50, Housing down biggest in 13(or 9) years, etc.., only to be followed by Bernacke's "it's working well"?

How about 30+ subprime lenders blowing up. New Century about to be investigate and stock fell over 70%. I can go on and on but I'm not a doom and gloom kind a guy. I just want to know what's really going so I can make the right trading decisions.

 

[Birchtree]

This board is not a federation of the Three Muskateers. I moved the Mrs out of her international on 1/23/07 and I had a reason for making the move. That noise is documented but was unheard - so what. We all take our chances - that's what makes a market.

 

[Fivetears]

Factually so, Dennis. But the thing is your wife's International investment could have gotten padded quite a bit more if you had the ability to calculate the overstretched carry-trade situation. Did you use an emotional risk tolerance, or did you have a spreadsheet running where the yen interest rates and value -vs- other world market currencies gave you the warning signal to leave. Poor market emotion is impossible to time. Gloom and Doomers. It's my opinion there is something going on, and it has to do with the carry-trade, and it's been identified twice in a row. However, it falls on deaf ears because it's being identified in terms of emotion; gloom and doom.

There has got to be some hard numerical figures on this out there. We were just not looking for them. I'm just saying... perhaps we should start, and this MB needs more than 3 Musketeers looking at it.

This board is not a federation of the Three Muskateers. I moved the Mrs out of her international on 1/23/07 and I had a reason for making the move. That noise is documented but was unheard - so what. We all take our chances - that's what makes a market.

 

[Fivetears]

Man I'm telling ya! It's like a crime show and you have a killer in the crowd. We had folks with the suspect in their sights, but not enough evidence to take 'em down. We cant let this happen again in 2008, or later this year towards Christmas. We need trackable numbers.

It's a tough call on what elements play what. Combining the need for a correction with the rise of the Yen with the Shanghai vertical climb with Greenspan's words with taking profits, etc... all add together.

I agree that we need a better way to guesstimate the odds of a cheap loan unwinding. Probably the best way to do it would be to see which central banks have cheap loans along with how inexpensive their currency is. If it looks like their currency is rising up fast - maybe breaking resistance - we need to pay attention.

 

[Birchtree]

You can never find the exact top nor the exact bottom on any index or market. I made a small move with my insurance money into the I fund yesterday - but have yet moved the Mrs out of her large cap back to international. Will probably do it in a DCA approach as we move up. This carry-trade money that has further liquified will be searching for a comfortable home and I think lots will be repatriated back to large cap funds in this country. Japan is currently for sale.

 

[Fivetears]

I say it gets put right back where it all came from... and then some. My only pondering concern centers around the US housing market limiting the amount coming our way. Investors may be more inclined to put all that sideline money Internationally; in other countries.

You can never find the exact top nor the exact bottom on any index or market. I made a small move with my insurance money into the I fund yesterday - but have yet moved the Mrs out of her large cap back to international. Will probably do it in a DCA approach as we move up. This carry-trade money that has further liquified will be searching for a comfortable home and I think lots will be repatriated back to large cap funds in this country. Japan is currently for sale.

 

[Fivetears]

Another great forum possibly tied to the use of foreign currency carry-trading.
http://www.tsptalk.com/mb/showthread.php?p=81968#post81968

 

[Fivetears]

A Dr. Vineer Bhansali writes this on February 2 this year...
Concerns that a shift in the dollar's exchange rate against the yen could trigger a debacle along the lines of Long Term Capital Management's near-collapse are not new, and have been expressed in one form or another for the last three years - which, as you point out, have been periods of fat profits for many hedge funds. The arithmetic of the carry trade was also laid out by Thomas Stolper at Goldman Sachs, whom you quote as saying that "an implicit but critical assumption for most carry traders was that the low-yielding currency appreciated significantly less than the interest rate differential". The threat of verbal intervention by the Group of Seven also looms.

However, these fears ignore the key calculus of risk for the carry positions. At no time in the recent past have option premiums for buying protection on the US dollar-yen, or US dollar-Australian dollar, been so inexpensive relative to the carry returns offered. In other words, while not an arbitrage, the likelihood is high that if you buy the higher-yielding currency financed with the lower-yielding one, and buy protection against the tail risk of an unwind as in the LTCM crisis, you will be safe in most probable outcomes.

The simple reason for this unique state of affairs - low volatility and high carry pairs - is due to an "invisible hand" collusion between sellers of exchange rate volatility via options ("everyone" is selling options as a means to generate income in their portfolios, including many developing central banks) and the authorities, which are setting transparent, low inflation rate policies. The two continue to feed off each other. Nothing short of a crisis of confidence can shake this fearful yet stable equilibrium. Waiting for that crisis, unfortunately, is unprofitable and, given the cheapness of protection against the tail risks, not the course of action you should expect most profit-driven speculators to follow.

http://www.ft.com/cms/s/582ce5bc-b262-11db-a79f-0000779e2340.html

 

[Rod]

Howard Simons, a strategist at Bianco Research in Chicago, thinks given how low Japanese rates are versus the rest of the world, the yen carry trade still has a long way to go in any unwinding.

And "the unwind, if it starts to occur - is not going to be a one-week occurrence. It's going to occur over a long period," he noted.

When markets are more volatile, expect big gains and big losses to come hard and fast, Roubini said, referencing the yen's abrupt movements during the Asian financial crisis, when the yen jumped as much as 12 percent during one 72-hour period in 1998.

"This is not a risky trade I would continue if I was an investor. Any trigger can cause a sudden movement at this point," Roubini said.

http://money.cnn.com/2007/03/05/markets/yen_carry/index.htm?cnn=yes