One of the catch phrases dominating news coverage of this month's financial skittishness has undoubtedly been "carry trade." All of a sudden, a complicated and somewhat obscure strategy for making financial bets on interest rate disparities was front page news. The practice involves taking out loans in low interest rate currencies (like the Japanese yen), exchanging the money to a currency with higher rates (say, the U.S. dollar), and re-loaning it out. You make more money in interest than you are charged on your initial loan, and if you leverage the bet you can make a killing. Unless interest rates change. And that, of course, is precisely what's been happening (Bloomberg) of late in Japan.
There aren't firm numbers on the exact size of the global carry trade; many of its practitioners are hedge funds, which aren't required to report their holdings. Global size estimates vary wildly, from about $200 billion to over $1 trillion. February's quarter-point increase in Japanese interest rates does not in itself nullify the attractiveness of many of these investments—the Bank of Japan's benchmark rate is still only 0.5 percent (Nasdaq International Perspective), exceedingly low by developed market standards (the same benchmark rate in the United States is currently 5.25 percent).
Still, the hike was enough to frighten some investors into thinking more increases could be on the way. These concerns, coupled with a strengthening yen, fueled fears a rapidly unwinding carry trade could negate a major source of financial liquidity worldwide. This, in turn, helped prompt cascading global stock market declines. Some analysts predicted the "carry trade will carry on" (Forbes); but former Federal Reserve Chairman Alan Greenspan said he expected the carry trade would wane (CNN) over the long term: "At some point it's got to turn," Greenspan said. If a return to market equilibrium is indeed inevitable, the major question for markets is when and how a turn might happen.
The broader story is the Bank of Japan's nudging up interest rates. After five years of staunchly holding rates at zero percent (BBC) in an effort to stave off deflation and boost the Japanese economy, the Bank of Japan in July 2006 raised rates to 0.25 percent, then hiked them another quarter point in late February 2007, to 0.5 percent. Analysts say the hikes may reflect underlying confidence in the Japanese economy, an uptick in Japanese consumer spending, or perhaps most significantly eased fears of the crippling deflation that hobbled Japan's economy (BusinessWeek) in the late 1990s and early 2000s. That said, more rate hikes may not be in the cards, at least not in the near future. As the Economist points out, Japan's government faces a major round of local elections in July 2007, and a rate hike this spring could prove sufficiently detrimental to candidates from Japan's ruling Liberal Democratic Party that policymakers might pressure central bankers to hold steady.