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Japan is back in the free-credit, dollar-bailout business

Section: Daily Dispatches

Yen Slumps Most in Nine Months as Interest-Rate Trades Resume

By Chris Young
Bloomberg News Service
Monday, August 28, 2006

SYDNEY, Australia -- The yen is heading for its worst month against the dollar since November as investors take advantage of Japan's low interest rates to finance trades in higher-yielding assets.

Investors are using the so-called carry trade to borrow yen at rates barely above 0 percent and use the money to speculate in the markets where central bank rates are as much as 14.5 percentage points higher.

Traders abandoned the strategy in the first half of the year as the Bank of Japan signaled it was preparing to raise borrowing costs for the first time in almost six years. They flocked to the carry trade this month, driving the yen lower, after bank Governor Toshihiko Fukui pledged to keep increases "gradual" and an economic report showed that consumer prices were rising at half the pace of analyst estimates.

"We like to have it as part of our investments whenever we think we can make it work," said Thanos Papasavvas, head of foreign exchange at London-based Investec Asset Management, which oversees $53 billion in assets. "We were negative on the carry trade in the first half of the year." Investec has borrowed in Japan to fund investments in euros, British pounds and New Zealand dollars, Papasavvas said.

The yen weakened 2.2 percent against the U.S. dollar and 2.1 percent versus the euro this month. It lost more against countries with higher rates, tumbling 5 percent against the New Zealand dollar, 4.1 percent against Canada's dollar, 3.2 percent versus the British pound, 3.2 percent against Brazil's real and 2.3 percent versus Mexico's peso.

Japan's currency on Aug. 25 dropped to a record low of 149.80 against the euro and 117.40 versus the dollar, its weakest in a month. It's headed for the biggest drop against the dollar since losing 2.9 percent in November. For the year, the yen has gained 0.4 percent compared with the U.S. currency and fallen 6.7 percent against the euro.

"The carry trade has been impinging on the yen," said Ryan Shea, a currency strategist in London at State Street Global Markets, which serves as a custodian for $10.7 trillion of assets. State Street has borrowed in yen through one-month forward contracts and invested in euros, Shea said. The European Central Bank's main interest rate is 2.75 percentage points higher than that of Japan.

In carry trades, investors borrow in a currency with low yields and sell it to buy securities in countries with higher interest rates. The sales weaken the borrowed currency.

A U.S. investor might buy a six-month certificate of deposit at about 5.25 percent and finance the trade by borrowing the money in yen at about 0.25 percent.

The investor earns the difference between the two rates. A $1 million investment would earn the 500 basis points between the two rates, which is about $4,000 a month, as long as the spot rate between the dollar and yen remains constant. If the dollar gains against the yen, the profit increases. If it falls, the profit declines.

"The trade has been around forever and the yen has been the one most widely used because the interest rates have been zero for so long now," said Jeff Gladstein, global head of foreign- exchange trading at AIG Trading Group Inc. in Wilton, Connecticut.

The yen has declined against 14 of the 16 most-traded currencies this month. The Bank of Japan's lending benchmark of 0.25 percent is 14.5 percentage points below Brazil's main rate, 6.75 percentage points less than Mexico's and 4 percentage points under Canada's.

Singapore-based investment strategist Benjamin Pedley predicts the currency will advance to 112 per dollar and 147 versus the euro by year-end, enough to wipe out earnings from higher-yielding assets.

"The carry trade is fraught with danger because the yen is so weak and because fundamentals suggest it shouldn't be," said Pedley of LGT Bank, a unit of Liechtenstein's LGT Group, with $63 billion of assets. "A 3 percent interest-rate saving per annum by borrowing in yen isn't sufficient reward."

A majority of Wall Street analysts have been surprised by the drop in the yen. As recently as six weeks ago, the median forecast among 44 strategists, traders and investors Bloomberg surveyed was for the yen to end the year at 108 to the dollar. The prediction in January was for the currency to strengthen to 110. The yen started the year at 117.75 versus the dollar.

The Bank of Japan raised its benchmark on July 14. Fukui damped expectations about further increases, telling reporters in Tokyo on Aug. 14 that "we don't have any preconceived notion" about pushing up borrowing costs.

Evidence of slower inflation emerged last week when the government said core consumer prices, which exclude fresh food, rose 0.2 percent in July from a year earlier. That compares with the 0.5 percent predicted in a Bloomberg survey of 29 economists.

"The Bank of Japan will probably be very reluctant to raise interest rates beyond the initial hike in July," said Max Tessier, vice president of currency management at CIBC Global Asset Management in Montreal. "You still have a huge interest-rate differential between the U.S. and Japan."

CIBC, which oversees $2 billion in foreign exchange, borrowed in yen to invest in pounds and may switch to buying euros and dollars in the next few months, said Tessier.

"Trades funded in yen are quite appealing," said David Mozina, a currency strategist at Lehman Brothers Holdings Inc. in New York. Mozina said he's telling his clients to borrow in Japan and buy Australian, New Zealand, and Canadian dollars.

This month's slide in the yen is the first time in nine years that the currency has lost ground in August. The month is typically the best of the year to buy the currency as Japan's investors bring home interest income from U.S. Treasuries, according to Merrill Lynch & Co. figures.

"The yen is still being used as a funding currency," said Mitul Kotecha, global head of foreign-exchange strategy in London at Calyon, the securities unit of Credit Agricole SA. "Against that background it's very difficult to see the yen appreciate in the short-term."

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