Return of the Yen Carry Trade

The revival of the Yen Carry Trade is yet again the talk of the town. With Yen hovering around 100 per USD, pretty much the same as of pre 2008 market crash, the discussion about Yen carry trade is catching up fast. The immediate triggers for this heightened interest in the Yen carry trade are because of the fact that the Japanese Yen has depreciated significantly against other major currencies such as the USD and the Euro. Besides, the massive quantitative easing policy of Bank of Japan is further fueling the fire. Carry traders crave for exactly the same opportunities what they are having now.

About Carry Trade

Carry Trade is based on interest rate arbitrage. The basic concept involves borrowing low interest currencies and investing in high interest currencies and bank upon the difference in the rates. And the profit increases several folds because these trades are generally highly leveraged. For instance, if a trader has 1000 USD of his own, he further borrows Yen worth 10,000 USD (say @ 1%) and invests in Indian Sovereign Bond @ 8%. Now, his total investment of 11,000 USD will give him a return of 880 USD as interest for 1 year. After paying back the borrowed Yen along with interest of 100 USD (@ 1%), he still makes 780 USD on his initial capital, a whopping return of 78% in a year. This may seem to be that simple but a lot of risks are also involved, the most important being the exchange rate fluctuations. Given the leveraged nature of the trades, even a slight unfavorable movement in exchange rates can lead to huge losses.

Yen carry trade was very popular in the period from early 2000 to 2007-08. After the 2008 Global meltdown, Yen appreciated rapidly against dollar and rendered the trades unviable.

Then and now

If you look at the pre 2008 and the current scenario, you will find similar factors that are extremely conducive to a Yen carry trade. Let’s analyze the important factors and see the similarities.

• Exchange Rates: For a profitable carry trade, the exchange rate needs to be highly favorable. Yen as a devalued currency is a superb fit. The current exchange rate of USD: YEN pair is similar to what it used to be during the pre 2008 period. In fact, forecasts call for the Yen to be further weakening in 2013-14 and may touch levels of 110 per USD. This makes borrowing Yen a great bargain. Look at the graph below which represents the USD: YEN exchange rate since 2008 and you will understand what I mean.

  

Source: Yahoo Finance

• Liquidity: Easy money is one of the prime requisites for Carry Trade. The 2000-2008 period saw huge surge in Yen carry trade and it was not just a coincidence that 2001-2007 was the period of the first huge quantitative easing policy in Japan. The entire period saw huge influx of Yen supply which combined with the favorable exchange rates led to carry trade on a very large scale. By the year 2007, it was estimated that some USD 1 trillion was staked up on Yen Carry trade.

Recently, the Japanese Central Bank, which has raised its inflation target to 2% up from 1% earlier, has announced for a massive quantitative easing program. It is set to infuse USD 1.4 trillion by the end of 2014 in the economy. Just to give you an idea, Japan’s quantitative easing program is 60% larger than the US quantitative easing program, according to the Wall Street Journal.

• Interest Rates: for a better interest rate arbitrage, the initial currency needs to be from a very low interest rate regime. Japan has maintained extremely low Benchmark Interest Rates after 1990s. No wonders why Yen has been the Blue-Eyed Boy for the carry traders. The chart below shows the historical interest rate data. Compare the rates in 2008 and 2013 and you will find another important similarity.

Source: www.tradingeconomics.com

Current Developments

As per the latest updates, the US Federal Reserves is going to have an effective change in its current policies. It is going to start tapering the quantitative easing and will reduce its bond buying by the year end. Fed chief, Mr. Ben Bernanke announced the change in policies by year end thus reducing the free flowing dollar supply to the market. Although this was a conditional declaration and the US WE tapering will see the daylight only in case of appreciable signs of strength in the economy.  And the conditions seem to be quite fulfilled. The June USD Jobs data was better than expected  and it pushed up the USD against major currencies. It’s a strong indication of tapering in the QE program by september, 2013. This is going to be a great favor to the Yen carry trade.

With historically low interest rates and easy availability of USD due to US QE policy, the Yen Carry trade has lost its appeal. But with expected tightening of dollar supply, things are going to change in the favor of Yen Carry trade. Whether or not, the Yen Carry trade gains traction is a matter of immediate future and the next few months may clear up the picture. But as of now, things are pretty much favorable and pointing to yet another period of huge bets on Yen Carry trade.

Article written by Patrik Fonce from quantshare.com.