Yen,Carry Traders Get Carried Away

The resurgence of the yen-carry trade has contributed to the feeling of ample global liquidity. But the tide could recede quickly if the dollar declines.

WHILE THE TALKING HEADS WiLL BE chattering this week about the Federal Open Market Committee's meeting, the real monetary intrigue is taking place in Tokyo.

The U.S. central bank's policy-set­ ting panel is certain to hold its federal­ funds rate target steady again Wednes­ day at 5Vt%, leaving Fed watchers nothing to do but parse the words ofits statement, which similarly is likely to be little changed. "Inflation is too high, and we think it's coming down but we're still on the case, yadda, yadda, yadda," or some­ thing to that effect will emerge from the confab.

Since the FOMC called a halt to rate hikes two months ago, the bond and stock markets have enjoyed sweet little ral­ lies. You may have read somewhere that the Dow Jones In­ dustrial Average crossed the 12,000 mark last week, a nice rise from 11,173.59, where the Blue Chips closed after the Aug. 8 FOMC meeting. In the bond market, the lO-yearTrea­ sury-note yield is down to 4.78% from 4.92% on Aug. 8, al­ though it's backed up from a low of 4.54% in late September.

The plunge in oil prices has been arguably a bigger factor than the Fed's move to the sidelines. Despite output cuts an­ nounced last week by OPEC, crude fell to $56.82 a barrel, down 27% from its August peak and close to a setting a 52-week low, notes Paul Hickey of Birinyi Associates. In­ deed. if clUde futures hit $56.14, it would be the first time they\\ill haye set a 52-week low since N ov.15, 2001-when oil bottomed out at $17.45.

One other factor appears to have been at work in the mar­ kets' adyance oYer the past couple of months-the return of the yen-carry trade. That involves bon'owing yen, which costs a fraction of a percent, to buy higher-yielding assets.

The strategy backfired earlier this year when the Bank of Japan ended its so-called Quantitative Easing, which in­ volves stuffing the channels with trillions of yen of excess liquidity to stimulate the domestic econ­ omy. That helped precipitate the spring selloffs in everything from the Icelandic krona to the U.S. stock mar­ket.

Expectations that the Japanese central bank would take the next step, to lift rates from zero, helped push the yen up sharply, to about 110 to the dollar by mid-May from around 119. And that's what put the kibosh on the markets. Even if the BOJ jacked up rates all the way to 1 %, it still would be the cheapest money in the world. But the Japanese currency's rise would mean nearly a 10% increase in the dollar value of a yen loan, a crushing blow to a levered speculator.

The yen has since gradually receded back to the 118-119 leyel to the dollar, and despite expectations of an eventual rise in Japanese short-term rates, theBOJ is still stuck at zero. Giyen the irresistible prospect of free money, the yen­ carry trade resumed in mid-summer, which Charles Dumas of London-based Lombard Research writes "is the chief ex­ planation of Wall Street's recent bull run."

Last Wednesday. however, the Nihon Keizai Shimbun re­ ported the Bank of Japan plans to increase its monitoring of the yen-carry trade because of its concern the tactic was pressuring the yen lower. The Japanese central bank quickly denied the report, telling Dow Jones Newswires it has not "strengthened its stance monitoring the yen-carry trade."

Taking the BOJ at its ,yard, one still wonders how Japan's leading business newspaper would run a story that named no sources if it didn't trust the story's veracity. A cynic might think the Japanese central bank would want plausible deni­ ability against accusations it was encouraging a cheap yen.

Japan's domestic economy has been showing signs of soft­ ening, writes Jonathan AllIDl of KEC Financial Products in The Blah!, his daily newsletter out of Tokyo. "The BOJ, in particular, seems in denial on this, arguing that the apparent signs of slowing/weakness are either a function of inade­ quate data or the weathel;" he writes. Absent support from domestic demand, Japan's economic recovery is heavily de­ pendent on capital spending and exports, adds Stephen Roach, chief economist of Morgan Stanley. In that case, the Bank of Japan would appear to be in no hurry to raise rates, which would boost the yen and hamper exports.

With the yen and Japanese interest rates capped, lever­ eraged speculators have been piling back into the yen-carry trade. ''What better way to add a little oomph to your year­ end performance than lever-up-borrowing at [0.25%] ina cw'rency that is all but guaranteed to remain weak?" writes Stephanie Pomboy of MacroMavens in her weekly missive.

The resurgence of the yen-carry trade has contributed to the feeling of ample global liquidity, observes F. Mark Turner, head 6fPentagram Partners, a Milton, Mass., global hedge fund. But, Pomboy warns, that tide of liquidity could recede quickly if the dollar falls, and by extension, the yen rises. The reversal of the yen-carry trade then could cause all sorts of havoc.

E-mail: randall.forsyth@barrons.com