Currencies: Yen carry trades - caveat emptor!
Summary
"Buyer beware"! We give you our thinking on whether this strategy is as smart as some think - at least during current market turbulence. We also re-iterate various timing issues - and suggest what sector to avoid. We also re-visit a piece about the direction of the yen that we released in the middle of March.Topics Covered
- How the carry trade works
- Clear pitfalls
- How to save money off this idea
Background
- How the carry trade works
Basically, you borrow yen at 0.5% per year, and then convert it into a currency with which you buy higher-yielding instruments. I used to do this happily against the baht, which was yielding 7% a year.
This means that when people place such a carry trade, they SELL yen in order to invest in a higher yielding asset that is denominated in another currency. And when they unwind their trade, they sell the foreign currency instrument that they invested in and BUY yen in order to repay the yen loan,
Today's South China Morning Post carried a revealing article on this. the key point, one that escaped me, is that it is primarily Japanese households who are behind this: getting virtually nothing at home, they sell yen and invest in higher-yielding assets overseas. But since the second half of 2006, they have got savvier, allowing us a clear pattern prediction, as we discuss next.
2. Clear pitfalls
Since April 2006, whenever America's S&P500 stock market index
- has risen, the yen has fallen, and
- has fallen, the yen has risen.
This pattern prediction makes sense.
- When America's stock market rises, people borrow cheap yen, sell it and buy dollars in order to buy American stocks - so the yen falls, and
- When America's market falls, people get cold feet. So they sell their U.S. stocks and take the proceeds to convert to yen in order to repay their yen debt - so the yen rises.
The most recent top on the S&P 500 was reached on 15th May 2008, when it stood at 1,424.57. Until yesterday, 26th May, it had fallen by 3.4%. Meanwhile, over the same period, then yen has risen by 0.7% against the dollar. If you annualize that yen gain, it has risen by over 50%! Now that is what I call a "bury" trade.
In another missive, Bankquakes, we noted that
"In part III of our recently-concluded mini-series, Stock Markets & Inflation, we suggested that the market will peak this October and then slump for a good year, i.e. "panic" sets in this October and stays stuck throughout 2009. That pattern prediction is based on our analysis of what happened during the past four stagflations."
So, if you agree with our leeriness, then do not go into the yen: carry trades are going to get unwound in line with the market unraveling, so you will have to pay more dollars to get the same amount of yen that you originally borrowed.
On 15th March 2008 we suggested a yen/$ rate of 90 by the end of this June. That is quite an aggressive call. But now that we have established the new pattern prediction since this April, the direction of the yen is clear: continued strengthening.
3. How to Save Money Off This Idea
- Always consult your financial adviser first
- Don't do yen carry trades until you feel that markets are going up again.
