Monday, March 05, 2007

Carry Trading is the Culprit

What is borrowed must be returned. This seems to be the explanation for the recent turmoil in financial markets. Apparently a lot of people have been playing a money game called “carry trade”.

Currency Carry Trade: Here's an example of a "yen carry trade": let's say a trader borrows 1,000 yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond for the equivalent amount. Let's assume that the bond pays 4.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 4.5% (4.5% - 0%), as long as the exchange rate between the countries does not change.

In an attempt to revive their economy, Japan has literally been lending money at no charge to borrowers eager to take the cash. Everything is fine and dandy as long as currency exchange rates stay essentially constant. The rest of the world, however, is actively adjusting interest rates to keep inflation in control and Japan is not immune to the effects.

What is the carry trade? However, monetary authorities throughout the world are now midway through a process of normalising interest rates, which had been slashed to support growth after the dotcom bubble burst in 2000, says the Financial Times. Britain is furthest down this track, with interest rates steady at 4.5% and inflation at 2%. The US is not far behind, with nominal rates already matching the UK and set to go higher. The tightening cycle in the eurozone may be put on hold, but not for long. Japan is a laggard – it is just approaching the “starting line”, with the country only just returning to steady growth, which might (or might not) lead to a halt to monetary easing in April and an end to zero interest rates by the end of this year. An end to Japan’s zero interest rate policy might lead to yen appreciation (low interest rates usually mean a weak currency), and so an end to those benign, “no brainer” conditions that have justified the ‘carry trade’ and been so supportive of other asset classes.

As the Yen suddenly strengthens last week a lot of money traders find themselves in tenuous situations. Gloom and doom emotions sweep through financial institutions where loosing money is not career enhancing.

Goldman Sachs warns of 'dead bodies' after market turmoil: Jim O'Neill, the bank's chief global economist, said investment firms playing the "carry trade" had been caught on the wrong side of huge leveraged bets against the Japanese yen. "There has been an amazing amount of leverage on currency markets that has nothing to do with real economic activity. I think there are going to be dead bodies around when this is over," he said.

Investing long term with borrowed money is always risky but not as risky as short term gambling from a leveraged position. Still, most financial institutions are controlled by serious sober banker types and Bloomberg finds evidence that all is not lost. The storm surge battering the markets may end up being less damaging than first feared.

Yen Snaps Three-Day Gain: The yen snapped a three-day rally against the dollar and the euro as Japanese stocks rebounded from five days of losses, suggesting investor risk appetite may return.

If the governments can resist stepping in to help, the world may yet avoid one of those poverty enhancing recession things. One thing for certain is that the situation is still fluid.