Carry Trade Beginnings
March 25, 2011
While keeping an eye on a whole smorgasbord of developments — Portugal, Libya, Fukushima reactor #3, Chinese growth, oil prices, and differences in the monetary stances of the ECB, Fed, and Bank of England — the most intriguing storyline just off the press is the reappearance of carry trading. A column in yesterday’s Financial Times under the headline “Yen action sets scene for return of the carry trade” captured the intrusion of this new, and old, factor.
In a carry trade, investors borrow funds in a low-yielding, soft-to-stable currency and invest them in high-yielding assets of a different currency. It’s hard to overstate the absolute currency market dominance of carry trades from 2001 to the collapse of Lehman Brothers in late summer 2008. The quintessential carry trade liability currency was the yen. From a low of JPY 88.95 on October 26, 2000, the same day it bottomed at $0.8228, the euro soared 91% to a high of JPY 170.00 on July 23, 2008, about a week after Europe’s joint currency also crested at $1.6038. At this past week’s highs, the euro was just 11.2% below its 2008 dollar peak, but it remained over 30% weaker than its all-time high against the yen. If the pendulum turns, plenty of room exists for the back swing.
Carry trading needs several conditions to thrive. For much of the last decade, the Bank of Japan was pursuing quantitative easing all alone with zero short-term interest rates and much lower long-term yields than found in other economies whose monetary policies were normal to restrictive. The Bank of Japan until March 2004 engaged in massive unilateral intervention to counter yen strength, and emerging markets sustained a brisk pace of global demand that fed upward pressure on commodity prices.
The Great Recession destroyed the easy money golden goose of carry trading. Japan still had very low interest rates, but so did all other advanced economies. Fear of deflation was no longer limited to Japan. Safety, not earning a good return, became the top priority of investing. For Japan, a country of savers and a chronic exporter of capital, it meant keeping wealth nearer to home, and that caused the yen to rise. The Great Recession infected many emerging economies and triggered very expansionary monetary and fiscal policies from the emerging economies as well as the more advanced ones. However, emerging economies showed off their 21st century nimbleness but avoiding the prolonged tailspin of the developed economies and instead traced a V-shaped business cycle with an impressive resurgence of both demand and production. One of the hallmarks of the carry trade era had been restored.
In the second half of last year, other changes prepared the financial community to reconsider carry trading. The euro area’s recovery did not fade significantly as had been widely expected. Also, inflation accelerated more steeply and quickly in Europe than assumed, and the ECB moved forward its timetable for tightening monetary policy. Meanwhile, the Fed engaged in a second round of quantitative easing, creating liquidity that would have to get parked somewhere against the backdrop of a rejuvenated risk-on preference by investors.
The final and most important piece of the puzzle was delivered by the massive Japanese earthquake on March 11. Japan’s economy had been showing signs of shaking off the negative growth of 4Q10 but now faced the prospect of a significant near-term setback. Paradoxically, the yen strengthened as investors foresaw a need for rebuilding infrastructure with capital that’s stored abroad. Fearing a double-whammy from the disrupted wherewithal to produce and a sharply firmer yen, Japanese officials prevailed on their G7 colleagues to conduct joint currency intervention for the first time in over a decade. That seemed to be the big news reported in this column one week ago. The yen would be kept stable by heroic means if necessary. To back up that perception, the Bank of Japan unleashed a torrent of yen liquidity.
One sees the extent of Japanese money printing in several ways. Excess banking reserves at the Bank of Japan have swelled to JPY 28.9 trillion, and bank current account holdings with the central bank averaged JPY 42.15 trillion (slightly over a half trillion dollars) this past week, up from a daily average of JPY 19.7 trillion earlier in March, JPY 16.8 trillion in 2010, JPY 8.08 trillion in 2008 and JPY 27.3 trillion from April 2002 to July 2006, which covers most of last decade’s experience with quantitative easing. Likewise, the central bank’s balance sheet shot up to JPY 149.8 trillion as of March 20 from JPY 133.3 trillion ten days earlier and JPY 126.2 trillion two months earlier. Practically overnight instead of in the progressive fashion done in 2001-5, monetary easing has leap-frogged beyond that earlier era’s maximum degree of stimulus.
Net currency movements in the week between March 18 and March 25 conformed to a classic carry trade configuration. As of 16:30 GMT today, the dollar had advanced 1.1% against the yen and 1.9% versus Swiss franc, another favored low-yielding currency to finance carry trading. In contrast, the dollar against commodity currencies had lost 3.1% versus the kiwi, 2.9% relative to the Australian dollar, which hit a 29-year high today of 1.0296, and 0.6% to the Canadian dollar. In spite of really difficult fiscal negotiations among EU leaders, the collapse of the Portuguese government, a double-notch downgrading of that country’s credit rating, and sharply wider peripheral yield premiums above German bunds this week, the euro remained well bid, trading above $1.40 throughout the period and climbing 0.7% on balance. Carry trade dynamics trumped very distressing regional news, reminiscent of the euro’s pre-Lehman upsurge to an all-time high of $1.6038 in mid-July 2008. And gold posted a record high in the week, symptomatic of investor distrust of all paper currency.
It will be necessary that the global economic recovery stay on track if the carry trade reaction is to continue in coming weeks and months. Next week offers up an abundance of top tier economic data releases. The U.S. slate is headed by the March labor force survey but also includes the manufacturing purchasing managers index and the Case-Shiller survey of home prices. Japan releases its quarterly Tankan survey of business conditions and expectations as well as a variety of monthly indicators like retail sales, industrial production and housing starts. Manufacturing PMI readings for a slew of other emerging and developed economies also get released April 1. Euroland sentiment indices, German retail sales, British GDP, consumer confidence and retail sector trends and Canadian GDP arrive in the coming week as well.
Next week will also provides a convenient reality check for the power of carry trade forces vis-a-vis other stories that are affecting investor sentiment. Does Euroland’s sovereign debt crisis survive the summit of leaders or take an additional big step toward greater chaos? How does the balance of power of warring factions in Libya shift, and what is the further response of oil prices to the unrest? What happens at reactor #3? What are the ramifications of German regional elections and the ongoing impasse between U.S. Democrats and Republicans over the budget and debt ceiling? Thursday marks the end of Japan’s fiscal year. To the extent that capital holdings abroad eventually repatriate to Japan to fund projects there, such was never likely to materialize discernibly until after fiscal yearend. Moreover, the yen historically tends to trade buoyantly in April, very rarely loosing significant ground that monthand occasionally advancing briskly. The first full week of the second quarter has some important central bank meetings. Chatter about an ECB rate hike should pick up pace as March winds down.
For the first quarter of 2011, meanwhile, the euro is trading now well above the mid-point of its quarterly $1.2875 to $1.4249 range thus far, and China’s yuan has appreciated since end-2010 at a disappointingly slow 2.0% annualized pace against a dollar at a time when the U.S. currency didn’t perform so well versus fully convertible currencies. Sterling reacted poorly to this week’s British annual budget and published minutes from the Bank of England’s early-March meeting but remains above the midpoint of its quarterly trading band of $1.5410 to $1.6401. The yen fluctuated during the quarter from as weak as 83.98 per dollar to an all-time high of 76.25 but spent almost the entire quarter in the weaker half of that range. The Swiss franc, like the euro, is presently much nearer to its strongest level, 0.8967 per dollar, than its quarterly low-point of 0.9785, but that bias would change if carry trading continues to seize control of world financial markets.
For readers in Europe, remember to set clocks forward one hour on Sunday morning. This change will restore the normal five-hour span between the time in New York and London and New York’s spread of six hours with major continental financial centers like Paris, Frankfurt, and Brussels.
Copyright Larry Greenberg 2011. All rights reserved. No secondary distribution without express permission.
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