Carry trades and the yen's 20-year low

Serious Money:  Economist John Maynard Keynes once said: "Markets can remain irrational longer than you can remain solvent."

His words are certainly applicable to today's foreign exchange markets where the Japanese yen has sunk to a more than 20-year low on a trade- weighted basis, despite the underlying fundamentals that suggest the currency should be moving in the opposite direction.

Carry trades are commonly cited as the primary culprit. The phenomenon is said to be large and directly responsible for the rich pricing in the market for risky debt.

What is a carry trade? At its simplest, an investor borrows in a low interest- rate currency and lends the funds in a high interest-rate currency. However, in reality borrowing or lending funds rarely takes place as investors are typically seeking leveraged carry.

Thus, players usually take an outright position in the forward market to exploit the forward premium of one currency relative to another.

This involves selling currencies that are at a forward premium, ie the forward exchange rate is higher than the spot rate and buying currencies that are at a forward discount - the forward exchange rate is lower than the spot rate.

This is equivalent to borrowing in a low interest-rate currency and lending in a high-interest rate currency.

An equilibrium condition of global financial markets - "covered interest parity" - states that the forward premium of one currency relative to another is equal to the interest differential between the two currencies; the high interest-rate currency is at a forward premium while the low interest-rate currency is at a discount. Indeed, this is how forward exchange rates are set in the marketplace.

Thus, borrowing in a low interest- rate currency and lending in a high interest-rate currency is the same as selling currencies that are at a forward premium and buying those that are at a forward discount.

However, neither strategy should yield predictable profits due to a further equilibrium condition - "uncovered interest parity" which states that the interest rate differential between the two currencies reflects the rate at which investors expect the high interest-rate currency to depreciate relative to the low interest-rate currency. Thus, investors should expect no profits as the currency market equalises the returns in both currencies.

Although carry trades should not yield predictable profits, equilibrium conditions are consistently violated over short horizons in the foreign exchange market. Indeed, low interest rate currencies tend to depreciate over short provides while high interest rate currencies tend to appreciate.

Thus, a carry trade typically provides investors with not only the interest rate differential reflected in the forward exchange rates but also the appreciation of the high interest rate currency.

Academic research reveals that carry trades have generated exceptional risk-adjusted returns over time. Since the late 1970s, a portfolio of carry trades that were continuously rolled over would have yielded investors stock-like returns with substantially less volatility.

Carry trades are believed to be largely responsible for the persistent yen weakness over the past two years. It's not hard to understand why, given the low level of interest rates in Japan relative to both the US and Europe. The potential profits become hard to resist when volatility is low as it is today, since this increases the probability that the forward contract will converge at the spot price. Estimates put the current size of the yen carry trade at $1 trillion though such numbers should be viewed with caution. Nevertheless, the level of speculation is undoubtedly large.

Although exchange rates are frequently misaligned over short periods, they do converge on fundamental value over long horizons. Fundamental models of value indicate that the yen is currently as much as 30 per cent below fair value. Productivity in Japan's tradable goods sector, its net international investment position and negligible inflation all imply that the yen should be strengthening. It will undoubtedly reverse the current trend at some point, though it is difficult to find a precipitating factor in the short run.

Firstly, the high interest rate differentials are likely to persist. Although the Bank of Japan recently increased interest rates to 0.5 per cent, rates are unlikely to move any higher until later in the year. Meanwhile, US rates should remain at 5.25 per cent while rates in the euro zone could reach 4 per cent by mid-summer.

Secondly, only Europe seems to be troubled by the yen's malaise. The US is not concerned while the Japanese believe that the depreciating currency will ensure that the economy does not return to deflation.

Finally, the weakness partially reflects the international diversification by Japanese investors, which is structural in nature.

Signs of excessive speculation in the yen are evident and a spike in the currency would undoubtedly have a ripple effect through the market for risky debt. However, it is difficult to identify a factor that will precipitate an increase in volatility and a reversal in the current trend. Nevertheless, the demise of the yen carry trade will not be pretty. It's simply a matter of time.

Charlie Fell is an independent consultant and lectures in finance and investment in UCD and the Institute of Bankers in Ireland