The Yen and the Carry Trade

You can't help but to notice the upward progress the Yen has made in recent days. Xpresstrade futures analyst Mike Zerembrski calls that formation a "rounded bottom" (there's a bad joke in there somewhere), and he's right. Today the Yen has pulled a skosh off the 3 week highs set last night, but the point of the recent rebound is whether it's signaling a coming rate increase from those wild and wacky guys at the Bank of Japan.

That's where the issue of the "carry trade" enters the picture. The "carry trade" is a pretty easy exercise once you get the hang of it: You (you being an institution or, a clever hedge fund) borrow in the currency of a country with low interest rates to invest in higher yielding assets in another currency. The Yen, from a country with interest rates near zero, has been the perfect currency to use for the carry-trade strategy vs higher yielding currencies like Brazilian reals, or even the Aussi dollar. What makes the carry trade fun is that the strategy can blow up in your face big time. (That is one thing I will never get for either of my sons - a chemistry set, unless they show a true gift for chemistry. It was a miracle I didn't maim myself, or accidentally blow my parent's house up with the chemistry set they gave me with I was around 10).

Yes, there is a big blow up potential, if not melt down potential with these carry-trades and that is due to the sheer volume (hundreds of billions of dollars worth) of the trades carried out. The exact amount is not known, which is scary in and of itself. Of course, the financial whizzes of today are as usual cocky and convinced that they have perfectly managed their risk and can get out before everyone else. To them 1998, the year of the last crisis, is merely the year the FDA approved Viagra, the year of the impeachment of Bill Clinton and the election of Jesse Ventura as Minnesota governor.

These carry-trades can simply blow up when the country with the low interest rates, unexpectedly raises interest rates and its currency suddenly rallies. Even a strong piece of economic data in a country like Japan can put the carry-trade players in jeopardy if its currency rallies sharply on the news. So the level of the Yen is something to pay close attention to in the days ahead, along with Japanese economic data. Adding further intrigue, the G7 countries are meeting in Germany this week and it's not expected to be Das Fest Haus for Japan. The European contingent is likely to complain loudest about the recent weakness in the Yen and the advantage it gives Japanese exporters, which has added to the weight of speculation that the BOJ will soon hike rates.

Incidentally, in digging through the web this morning to make sure my impression of the carry trade situation isn't in the looney bin camp, I came across a very interesting write up on some credit crunch thoughts from Merrill Lynch. Click here to read.