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CARRY TRADE NOW FUNDED BY DOLLARS

BORIS SCHLOSSBERG<br />DIRECTOR OF CURRENCY RESEARCH, GFT<br /><br />One of the more curious developments over the past month has been the appreciation of the Japanese yen along with high-beta risk currencies such as the euro, the pound and the Australian dollar. Since the start of this decade, the dynamic that dominated currency trading saw the yen decline whenever risk appetite increased &ndash; especially as traders piled into the carry trade selling the yen against higher yielding currencies. But after reaching a high of 97.00 in early August, dollar-yen has plummeted to hit a recent low of 90.30, while the euro and the Australian dollar simultaneously hit yearly highs as risk appetite continued to expand.<br /><br />Why is this happening? One the reason for yen&rsquo;s strength is due to the change of power in Japan. After nearly 50 years of uninterrupted rule, the LDP party of Japan was defeated in elections by the upstart DPJ. Unlike its predecessor, the DPJ intends to stimulate the economy through domestic spending rather than export growth. The DPJ is far less concerned about a strong yen, and may in fact welcome it as appreciation in the currency increases Japanese consumers&rsquo; purchasing power of the Japanese. With intervention no longer a threat, yen bulls have been more aggressive, first breaking the 92.00 level of support and now eyeing 90.00 as the next psychological barrier to give way.<br /><br />However, politics is only part of the answer. The true reason may lie in the changing nature of the carry trade. Although Japanese overnight interest rates are lower than those of the US (10 basis points versus 25 basis points), the three-month Libor rates show that it is cheaper to borrow dollars rather than yen. Traders are choosing to do fund their carry trades in dollars rather than yen. And if US rates remain stationary for the foreseeable future, dollar weakness could become universal during times of risk assumption in the currency market.<br /><br />Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read commentary on currencies at www.GFTUK.com/commentary or e-mail them at BorisandKathy@gftuk.com.<br />