Stephen Jen Demands Differentiation in the Debate

If you are really into currency markets I guess you want to read Stephen Jen over at Morgan Stanley's Global Economic Forum, at least sometimes I would argue. I don't think am much into currency markets or that is to say that I am not much of trader (litterally). However, I do have an interest in currencies from a macroeconomic perspective and specifically I have been interested (as everybody else :)) in the yen carry-trade as of late. I guess this is exactly the important point here. There has been a lot of talk on the Yen lately and specifically European policy makers have voiced their concern that the Yen is grossly undervalued against the Euro which hurts European exports. Also the recent G7 summit in Essen Germany mentioned the Yen although not in as a harsh manner I had expected. In stead of actually stomping on the BOJ or for that matter the Japanese ministry of finance the high lords suffised to declare that the Japanese recovery was on track ... ermm ok, but I am not so sure here and especially not when it comes to the domestic economy and as such the BOJ's ability to raise.

But what about the general debate on carry trade and the systemic risk epitomized by the huge amount of sensitive leveraged positions held by for example hedge funds ... are we really drawing the sketch for a big unwinding here? Well, Roubini certainly seems to think so but Stephen Jen is not sure and in fact in the latest issue of MS GEF he voices a criticism in terms of the overall current debate and discourse, as it were, on the carry trade. Jen makes several points but perhaps the most important point is that nobody really knows how big the carry trade is and most importantly nobody knows how big the supposedly disruptive carry trade is. As such, Jen also notes how carry trade is not well defined in the overall debate and how we should distinguish between different types of carry trade in order to get the full picture.

We find the discussion on JPY carry trades a bit disturbing.  (1) Since the concept of ‘JPY carry trades’ is ill-defined, it is misleading, in our view, to come up with a single-number estimate of the size of JPY carry trades.  Specifically, given the vastly different types of JPY carry trades (conducted in the spot, forward and swap markets), we don’t understand how some commentators can sum up numbers that are intrinsically not additive.  Further, there are types of JPY carry trade that are benign and stable, and other types that are destabilizing.  Talking about JPY carry trades as a homogeneous group of investments is misleading.

As always, Jen offer his thoughts in more detail and he also does revert to saying that the build-up of unsustainable Yen-short position poses a risk.

Again, as we argued above, merely asking ‘how big are these JPY carry trades’ misses the point.  If there were indeed massive Type 6 JPY carry trades [Type 6 JPY carry trade may consist of off-balance sheet swap positions.], then policy makers should be worried.  However, if most of these ‘carry trades’ are Type 4 (currency hedging of equity positions) or reflect a structural shift in the way Japanese investors think about foreign currency risk, then the policy implications are more benign, as these positions are logical and don’t deserve countermeasures from the authorities.

So, am I with Jen here? Well, I certainly don't want to disagree in so far as goes the need for a differentiated and nuanced debate. Essentially, it all boils down to the character of outflows from Japan and here Jen argues that most of the capital flows are of a benign nature but that risks are mounting for the unsustainable build-up of Yen-short positions. Well, talk about being back to square one eh? I have one gripe though and this concerns hedge funds; Jen argues that there is not much evidence of hedge funds being engaged in global asset prices build up. Well ok, I don't have a counter argument in terms of the empirical evidence but since these investors are very much engaged in the kind of financial instrument markets we are talking about in terms of carry trading which exploit the interest rate spread between the BOJ and other CBs to go short Yen and well long anything else I do think that leveraged short yen positions within hedge funds are much worth looking closer at.