from Follow the Money

A trillion dollars gets my attention, whether it comes from the PBoC or the yen carry trade

February 2, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Tim Lee of Pi Economics estimates that about a $1 trillion of private money is now betting that the yen will stay fairly weak.   

Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets. 

I certainly do not know if Lee's estimate is right.  I am pretty sure that the size of the yen carry trade is far bigger than $34b (the net open positions on the Chicago Futures Exchange).   I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most.  Her excellent FT article spells out the various ways cheap yen have influenced global markets -- and not just the obvious ones.

Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fuelling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults.  No wonder investment banks have been so profitable. 

Of course, the biggest carry trader of them all is the Japanese government.  It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back. 

In 2003 and 2004, Japan's Ministry of Finance (MoF) issued yen liabilities to finance enormous dollar purchases.  Japan -- counting the BoJ's reserves along with the MoF's reserves -- now owns about $750 of dollar and euro securities (not all of Japan's roughly $900b in reserves are in securities, some are in the bank).  

That trade has paid off.  Big Time.  The MoF borrowed in depreciating yen to buy appreciating dollars -- and got a bit of carry in the process.  And the MoF did it on a truly enormous scale. 

A private investor might even want to start to take some profits .... 

Of course, if the MoF started to unwind its carry trade, that might move the market.  And it might trigger some of the Japanese "real" money now playing the carry trade to reconsider.   The FT's Lex seemed rather confident that Japanese retail investors (Mr and Mrs Watanabe) will want dollars, kiwi and pounds so long as Japanese rates are low, no matter what happens in the foreign exchange market. 

I am not so sure.  I doubt most retail players remember just how far and how fast the yen/ dollar moved in 1998.  I calculated the cumulative inflation differentials (CPI inflation) between the US and Japan since 1998, and, if I did the math correctly, Japanese prices today are down 3% since 1998, while US prices are up 23%.   I think that means that a yen/ dollar of 121 is about equal to a yen/ dollar of 152 in 1998 in real terms.    It wasn’t that weak in 98

Bottom line: a ton of people -- the Japanese government and Japanese "real money" as well as the leveraged community -- are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.  

Then again the yen dollar and even more so the yen euro are not the only prices in the global economy that seems out of line to me ...

The yuan looks misaligned, to be sure.  But also think of the Saudi Riyal.  It has been pegged to the dollar forever.  Which means that it has slid v. most of Europe even as oil has soared.  Moreover,  Saudi inflation levels – at least recorded inflation levels – have been consistently below US inflation levels.    If you plot US-Saudi and US-Japanese inflation differentials on the same graph, there isn’t much of a difference. 


I understand Saudi deflation in the late 90s.   Oil prices tanked. The dollar soared.  Deflation was the only way to generate real adjustment without abandoning the peg.  

But I sure don’t understand why the riyal has – again, if the data is right – depreciated by about 10% against the dollar since 2002.   That doesn’t make sense.

To be honest, I don’t fully believe that data.  Service inflation is probably undercounted.   Still the riyal is, like the yuan and yen, misaligned.   It may not have depreciated in real terms v. the dollar, but it certainly hasn’t appreciated in real terms against the world since 2002.  And oil is worth a lot more now than then.

Saudi Arabia has more oil – and makes more money – than even Exxon Mobil.   Its profits (calling the increase in SAMA’s foreign assets profits, which isn’t strictly speaking accurate) were about twice those of Exxon Mobil in 2006.   Exxon Mobil is worth a wee bit more now than in 2002.  The Saudi riyal is not.

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