ONE of the big stories of the past six months has been the growth of the dollar carry trade. This trading strategy uses a low-yielding funding currency to purchase higher-yielding assets. For most of this decade the yen has been the funding currency of choice as investors took advantage of Japanese interest rates that remained at or close to zero. Since the Federal Reserve Bank cut US interest rates to 0.25 per cent, traders have been funding the carry trade with dollars.
But the latest data published by US regulator CFTC shows that speculators have trimmed their long positions in the yen since the end of November, suggesting that investors are bearish. A weak yen boosts returns when you use it as a funding currency for a carry trade.
So should investors be looking to pull out of their dollar carry trades and return to the yen? Perhaps not – or not yet, anyway. One of the reasons is volatility. The carry trade thrives in a stable economic environment, because it is by definition risky. Not only do you have to take into account interest rate differentials between two countries, you also have exposure to currency fluctuations.
At the moment, volatility in yen crosses remains at historically high levels. As graphic one below shows, the volatility in sterling-yen, although below its peak after the immediate aftermath of the collapse of Lehman Brothers, is still at the top of its long-term range.
Furthermore, there is also a lot of political risk in Japan right now, especially surrounding the country’s fiscal position.
Japan has plunged back into deflation, its exports are stagnating and it needs to deal with a massive fiscal crisis caused by a ballooning public debt. Japan has already outlined an $81bn economic stimulus package, which helped put downward pressure on the yen after it reached a 14-year high against the dollar. Another stimulus package is also in the pipeline.
All of this means that the yen remains unattractive for carry traders and the dollar remains the wisest choice as volatility levels on dollar pairs have fallen at a faster rate than on yen crosses.
There are three reasons for the dollar to beat the yen as the funding currency of choice. Firstly, the dovish Fed. Obviously, low interest rates are a precondition of a funding currency, and the US looks unlikely to raise rates any time soon.
Bank of New York Mellon analyst Neil Mellor says that the US is scared of entering a 1990s-style Japanese lost decade where growth remained sluggish causing deflation. “The Fed will not raise rates (in 2010), which means the yen won’t return to its position as the main funding currency,” he says.
Secondly, protectionist measures from Congress could weaken the dollar in order to boost demand for exports. Dollar weakness boosts returns when you sell it short.
Thirdly, the dollar could also benefit from the fact that the number of supports that boosted the yen carry trade in the past are no longer present. The yen’s position as chief funding currency during the previous carry trade binge was driven in part by Japanese retail investors with a high savings rate. While interest rates in Japan remained extremely low, domestic investors looked elsewhere to try and find returns. But this time domestic yen outflows have not been as strong. The main reason for this is a declining savings rate, which means the bulk of savings that previously were available to pile into foreign assets is no longer available.
In fact, it is worth wondering whether the post-crisis world will lend itself to carry trades at all. Most developed economies are being propped up by stimulus packages. These will not last forever. As Stephen Gallo of Schneider FX says: “That is a huge risk (for the carry trade) as the stimulus wears off we will see a retrenchment in asset prices.”
Like all risky investments, the carry trade hates an uncertain economic environment. But as we navigate our way out of the mess left by the financial crisis, it is possible that calamitous events are still possible. Dubai World proved this. These sorts of events can only deter carry traders.
Those who want to get in on the carry trade might want to look at short-term versions. Schneider FX suggests going short the US dollar and long the South African rand, where investors can gain from the interest rate differential.a