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CHINA BUBBLE IS A RISK FOR YEN SHORTS

BORIS SCHLOSSBERG
DIRECTOR OF CURRENCY RESEARCH, GFT

ASK FX strategists what their favourite trade for 2010 is and the chances are most will say long dollar-yen. The conventional wisdom in the forex market – despite last Friday’s disappointing US jobs data – is that US short-term rates will inch higher.

Their choice of trade is reinforced by the fact that Japan’s new finance minister Naoto Kan is decidedly more dovish than his predecessor. His preference for dollar-yen at ¥95 or higher has led traders to believe that Japanese authorities will encourage yen weakness to help exporters.

For the time being, the consensus view appears to be right on the money. Even after last Friday’s US jobs report, the yen only rose modestly against the greenback and saw much greater moves against the euro and the pound. Part of the reason for this relative weakness is that the yen carry trade is back.

Last summer, many investors changed to the dollar as their funding currency of choice. But with the market convinced that the Fed will hike rates sooner than the Bank of Japan (BoJ), speculators have once again turned to the yen.

As long as the global recovery maintains its pace, the long dollar-yen trade should prove profitable, but traders cannot afford to be complacent. The biggest risk may not be a sluggish rebound in the US, but rather from the possible burst of asset values in China.

Last week, authorities raised rates on short-term bills to temper credit growth. If this causes Chinese capital markets to stumble, the resulting wave of risk aversion will decimate the freshly-laid yen carry trades, as traders scramble to cover their positions. Therefore, traders long dollar-yen should watch the Shanghai stock market for early warning signs.

Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read daily commentary on currencies at www.GFTUK.com/commentary or e-mail BorisandKathy@gftuk.com.