A Cautionary Tale on Carry Trade Unwinding
I have had mixed feelings about reading Nouriel Roubini's blog as of late since I think his crisis mongerings on the US economy had become a bit too easy to predict. However, Professor has been diversifying his writings lately perhaps because the US data is beginning to go against his predictions or perhaps because he just felt like writing about something else. In any case, Roubini takes up the baton on a subject he previously has also devote some time to, namely the (yen) carry trade and the risk of a rapid and rumbly unwinding. The note obviously includes a lot of 'ifs' but still it is a good read.
Let me tell you a cautionary tale for 2007. The Yen has been weak and has kept on depreciating sharply for the last few months relative to the US dollar. Still mixed and weak economic data are coming out of Japan and short term interest rates there are still 0.25% while they were closer to 5.5% in the US; so the yen is weak and weakening. Massive amounts of carry trades using the yen – and the swiss franc – as the funding currency have been going on for months now leading to sharp increases in leveraged positions by investors who have been shorting the yen to play the carry trade bet.
The gist of Roubini's note is that the current global economic environment to a large extent is mirrored in the environment which triggered a financial crisis in 1998 as Russia defaulted which caused ripples throughout the global economy. This time around Ecuador is mentioned as the possible catalyst as the country seems bend hell on defying its creditors. The cautionary tale then goes something like this ...
Then, the yen starts to appreciate again – by a sharp 9% in one month - when a small emerging market economy defaults (Ecuador soon?) and a large hedge fund goes belly up (another Amaranth?). Then, suddenly one piece of good news comes out of Japan (a growth pickup?) and in a matter of 72 hours the yen appreciates by 12%. Then a major global macro hedge fund loses $2 billion dollars in 48 hours on the yen unraveling and decides to close shop; another one loses billions too and decides to restructure its operations. Carry trades unravel rapidly, margin calls are triggered, levered positions go belly up and the entire financial system goes into a seizure. Then the Fed is forced to cut the Fed Funds rate in between meetings by 75bps (in spite of still good US GDP growth) in order to avoid a financial meltdown, a collapse of US financial markets and a global recession.
So, do I subscribe to this view? Firstly, we have a default in Ecuador and whether this would have the same effect on global markets as in 1998 where investors basically got the 'risk aversion' bug and fled emerging market debt rather abruptly which caused a financial crisis most notably in East Asia. Could this happen with Ecuador? I am not so sure since a lot has changed since 1998 and we might just need a new way to look at the global search for yield and thus emerging market debt. Then of course we have the situation in Japan where it should be well known for readers here that I do not believe that the BOJ will be able to contribute much to the unwinding of carry trade through the raise of interest rates. This does not of course mean that carry trading and more specifically the huge leveraged positions held by hedge funds do not present an issue in and ot itself sinc this fundamentally represent an imbalance in the way capital flows. So in the end I am not sure I agree with Mr. Roubini here but still his points on this are well worth contemplating.
I think the bloggers at RGE are in 'carry trade mode' or perhaps it is just a coincidence. I really do not know, what I do know however is that Brad Setser has two excellent notes up on carry trade, what drives it, why it is profitable and even notes on how specifically to carry out a carry trade investment. Great stuff!
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.
Andrew Rozanov of State Street knows a thing or two about how official institutions manage their money (that is a big part of his current job) and a thing or two about Japan (he was based in Tokyo for some time). In response to my previous post, he noted that much of the yen carry trade is now done through the swaps market – or off balance sheet. Hedge funds don’t really need to “borrow” yen and then buy higher yielding currencies – they do the same thing in the derivatives market, or pay a bank to do it for them. I have – with his permission – reprinted his comment below. It inspired a nice discussion.