Tuesday, November 17, 2009

The Carry Trade

In about 1995, the Bank of Japan lowered their interest rates to nearly zero. This invited investors to borrow from the BOJ since it was so cheap. Investors borrowing at low interest rates in yen used the loan to buy higher yielding assets elsewhere. Perhaps the most popular form of the strategy exploited the gap between US and Japanese yields. Anyone borrowing for next to nothing in yen, convert it into US dollars, and putting the money into US Treasuries (US government bonds) paying 3 1/2% got a double pay-off: from an interest rate difference of more than three percentage points and from the dollar’s rise against the yen (when they reversed the trade and paid back the yen loan, they needed to re-convert USD into yen.. and by the time this happened, the yen had fallen even further). It was called the "Yen Carry Trade".

When the yen began to appreciate (in about 2006 the BOJ began hiking rates), those investors had to pay back those loans with more interest.. and so they began to repay ASAP in order to get the lowest payback possible as the BOJ raised rates again and again. By then, the yen was also badly undervalued, and forex speculators "bought" the yen. As the exchange rate of yen vs other currencies went up (very quickly), the second part of their scheme also went to pot and those investors then took yet more losses on the re-conversion from the local currencies back into yen. The yen went from 8,200 in mid-2007 to around 11,500 by the end of 2008: http://futures.tradingcharts.com/chart/JY/M

This flood of cheap money also helped in large part to fuel the speculative bubble in Asia in the mid-1990's; investors would borrow from the BOJ, convert it to the local currency (thus making the local currency go up in value) and invest it in their stock markets & real estate. These nations' stock markets & currencies rose to unrealistic levels, with predictable results. Worse, as their currencies went south, their governments had to borrow money at higher interest rates to make up for the collapsing currency value. Thus came the Asian Economic Crisis of 1997, with the IMF needing to bail out Korea, Thailand and a few others.

Here we are in 2009.. and this time, it's the US that has drastically lowered interest rates. This carry trade is large part of why the US dollar is sinking (investors are selling USD and buying other currencies to invest in those nations.). It's also part of the reason why our own stock markets are going up and why Bonds have not had a particularly difficult time finding investors. Here's an article from Hong Kong's governor, who also saw the 1997 debacle, on the Dollar Carry Trade: http://www.bloomberg.com/apps/news?pid=20601068&sid=aU3AiTc_Q_vk

The danger here is the same as with the yen trade.. that at some point, the USD could rebound violently, with profound repurcussions. This is a video from Nouriel Roubini, one of the few economists who saw last year's crisis, on the Dollar Carry Trade: http://www.youtube.com/watch?v=xIEoa3F5o0M

It's just these types of currency games that make small problems into very dangerous ones.


  1. Wow. It is very strange reading of such an event, and looking at our current situation. Most people in those countries, probably, did not think that these outside investors would ruin their narket system. I was just reading a few articles debating how to tackle the recession, and one idea tied with what this article was saying about bonds.

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