Asiamoney.com: Markets fret about the carry trade

April 2011

Asiamoney.com

Private wealth managers across Asia breathed a sigh of relief late last week when the G7 nations followed Japan’s finance ministry and central bank in intervening to drive down the value of the yen.

Let’s be charitable and imagine that some of this relief stemmed from the real matter at hand: the fact that selling the yen, after its appreciation to a record of 76.25 against the US dollar, would help Japan in its recovery from the terrible events it had endured in the previous week. A soaring yen was going to wreck exports at exactly the worst time for the country; right now it needs everything it has going for it, not more hurdles. The actions of the G7 nations – and there are expected to be more – were primarily an expression of solidarity with Japan when it needs it, as well as a natural desire to maintain stability in world financial markets.

But there’s another reason the private bankers were cheered. They had spent much of the week taking calls from clients deeply troubled by the climbing yen.

Remember the yen carry trade? Before the financial crisis it was all the rage, for its peerless simplicity. Borrow in yen, with a next-to-zero interest rate; invest the proceeds elsewhere to earn a greater return. If you want to keep it relatively risk averse, just put it in Australian dollar government bonds or an Aussie bank account; a 6% risk-free differential, even prior to the financial crisis. New Zealand and, for a time, South Africa were other recipients of this trade. It works a treat – provided the currencies stay stable, or more specifically, provided the yen doesn’t start climbing dramatically and wipe out the gains.

Several years ago there was widespread concern as the yen did start moving and the high-yield currencies like the Australian dollar went into decline. The carry trade started to unwind and there was a great deal of concern about the impact this would have on global financial stability. The world didn’t end; currencies like the Aussie dollar, underpinned by emerging market demand for local commodities, swiftly went most of the way back to where they started from. People stopped talking about the yen carry trade. But it’s back. In fact, it’s been back for a couple of years now.

Hence the alarm when, post the earthquake and tsunami, the yen counter-intuitively leapt to record strengths – based on the theory that Japanese businesses would repatriate overseas capital home where it was needed. Suddenly a lot of clients found their trade unraveling. Getting six percentage points of yield differential from Japan to Australia is all well and good, but not if the yen is going to appreciate by 10 per cent and make it a losing trade.

In truth, the yen carry trade has evolved somewhat over the years, because these days it applies to so many other currencies beyond the yen. You can borrow in US dollars for almost nothing and invest the proceeds elsewhere. You can borrow in sterling, in euros. The gap between major currencies and second-tier commodity currencies, in terms of the interest rates you can earn in these currencies, is bigger than ever. So really, the important cross-rate for private banking clients is not so much the yen versus the dollar – there’s no point borrowing in yen to invest in dollar assets – but the yen against whatever currency you put your assets in, which is a slightly different story.

But the whole experience has underlined the fact that, for all the probity and caution that came with the financial crisis, people do continue to expose themselves to trades that are vulnerable to sharp movement. Asiamoney spoke to three client-facing staff at three different private banks – two multinational, one Swiss private – and they all spoke of the drama of the week and the fear that clients had for a sharp climb in the yen. Which begs the question: has anything really changed in the way the wealthy invest, and are advised to invest?