Currency and Gold Update (Jan. 31, 2007): Yen carry trade and the danger of dynamic hedging

Yen carry trades are strictly interest rate arbitrage plays between US Dollar and Japanese Yen. In the narrow sense yen carry trades imply the activities of speculative money to borrow Yen at near zero rate, sell the borrowed yens for dollars, and use the acquired dollars to buy higher yielding dollar denominated debt instruments. In the broader sense yen carry trades also include the activities of Japanese financial institutions to sell yens at hand for dollars and use the acquired dollars to buy higher yielding dollar denominated debt instruments. Large scale installation or unwinding of yen carry trades always causes sharp movements in the exchange rate between Yen and Dollar. It should be noted that many financial market observers and media do not follow this definition of yen carry trades, but attribute any sharp drop in price of anything traded on the market as caused by the unwinding of yen carry trades. The most notable example of such misinterpretation occurred in September of 2006 when oil price dropped sharply and was widely reported as due to the unwinding of yen carry trades. At that time the exchange rate between Yen and Dollar was quite stable; actually Dollar was gradually strengthening against Yen during the turmoil of oil price, a completely opposite phenomenon to the unwinding of yen carry trades. The sharp drop of oil price was simply due to the sell pressure in the speculative futures market of oil and had nothing to do with the unwinding of yen carry trades. It should be noted also that during another sharp drop of oil price in January of 2007, those observers and financial media refrained from blaming the unwinding of yen carry trades as the culprit.

The installation of yen carry trades of the narrow sense will push Dollar sharply higher against Yen in a short period, but does not have the power to sustain the overvalued Dollar for long. The role of this kind of yen carry trade is to induce Japanese financial institutions to jump into the play. Once Japanese financial institutions join in and yen carry trades of the broader sense are installed, the trend of overvalued Dollar will continue for quite a while due to large amount of yens in the hands of those Japanese financial institutions. The power of yen carry trades to boost the value of Dollar and induce the run away US trade deficit was vividly displayed in the latter half of 1990's when Japan has dropped its interest rates to near zero level (see article 1). The undervalued Yen vs. Dollar also forces Euro to be undervalued against Dollar, too, since many European goods compete with made in Japan products. Undervalued Yen and Euro then gives China an excuse to appreciate Yuan vs. Dollar slowly. It is the undervaluation of currencies of US trading partners that is sustaining US trade deficit and thus the global liquidity glut. We may say that yen carry trades serve as the linchpin to translate near zero Japanese interest rates into global liquidity glut and thus the robust economic growth from US to China. It is why financial markets are so nervous about Japanese central bank's interest rate movement; they fear that rising Japanese interest rates will cause the unwinding of yen carry trades and thus put an end to the global liquidity glut. It should be pointed out that for yen carry trades to unwind purely from interest rate gap consideration the gap between US and Japanese interest rates needs to narrow substantially, for example, to below 2% from current 5% level. However, it is highly possible that a large downward fluctuation of Dollar from various other causes will trigger massive unwinding of yen carry trades with no regard to the size of interest gap. The unwinding of yen carry trades then triggers a wholesale collapse of Dollar. The dynamic hedging strategy is a top candidate for such a disaster scenario.

When Japanese financial institutions, like life insurance companies, engage in yen carry trades, they tend to buy long term Dollar denominated debt instruments, since their obligations to Japanese life insurance purchasers are long term in nature. The largest enemy to yen carry trades is the depreciation of Dollar vs. Yen. At the time of explosive growth of derivatives, those Japanese financial institutions naturally employ hedging against the unavoidable eventual fall of dollar through derivatives. However, straightforward hedging against a falling dollar is prohibitively expensive. Those Japanese financial institutions probably employ sophisticated computer based hedging techniques to make hedging affordable, but those techniques essentially all can be classified as variations of dynamic hedging. What is dynamic hedging? It is a kind of mental hedging long known to many investors. In one word they are the tactic not to hedge at all so the hedger does not need to pay any premium on derivatives since he does not buy any of them. The hedger only pledge to buy certain amount of hedging derivatives to protect a portion of his portfolio if dollar falls vs. yen by a certain amount, and gradually increase the amount of hedging as dollar falls more and more. In the modern financial management, the decisions of hedging are written into computer programs waiting to be executed in case of a falling dollar. If only a small portion of market participants engages in this kind of dynamic hedging, the strategy works fine. If a large number of participants are all using dynamic hedging, this strategy then turns into a grandiose false-sense of security. As dollar fluctuates down sharply against yen, large amount of hedging will be installed. The opposite sides of those hedging activities will be selling dollar short to cover their naked exposure, and will drove dollar down further. More hedging will kick in by computer programs under this dynamic hedging strategy. Very quickly the premium of the hedging derivatives will skyrocket and become beyond the reach of those Japanese financial institutions, and then they are forced to unwind yen carry trades in wholesale even at the time that the interest gap between dollar and yen stays very wide.

It is instructive to look back at the occasions of sharp drops of dollar to see the reason behind each movement. As discussed in article 1 the near zero interest rate policy of Japan, starting from the middle of 1995, induced the yen carry trades and pushed dollar sharply higher. At the middle of 1998 a massive unwinding of yen carry trades occurred and pushed dollar substantially lower against yen. The interest rate gap between dollar and yen was sustained at around 5% level throughout the rout of dollar. Another fall of dollar in the middle of 1999 was similar in nature, not from the shrinkage of interest rate gap. The fall of dollar in the spring of 2002 was due to the unwinding of yen carry trades induced by the sharp narrowing of the interest rate gap; FED started to lower interest rates to fight the recession and the interest rate gap had shrunk to around 1% level, too narrow to sustain yen carry trades. The situation of narrow interest rate gap had persisted until the middle of 2004. Therefore, the massive dollar selling from the fall of 2003 to the spring of 2004 had nothing to do with yen carry trades since the condition to install yen carry trades was absent at that time. That massive dollar selling was induced by pessimism about the future of dollar, a view widely held among long term investors at that time. Eventually Japanese government bought up 400 plus billion dollars during that period to prevent the wholesale collapse of dollar. Since the middle of 2004 FED has pushed up US interest rates by a substantial amount, recreating the favorable condition for yen carry trades. The value of dollar has risen steadily from about 100 yen/dollar to the current level of over 120 yen/dollar.

Three years has passed since the last massive dollar buying operation of Japanese government. Dollar-selling pressure should be building steadily due to continued large trade surplus of Japan. Though it is difficult to say when and how a large enough downward fluctuation of dollar will occur that will trigger the dynamic hedging frenzy and the subsequent unwinding of yen carry trades, the probability for such a disaster increases as time passes. If such event happens, Japanese government needs to reopen its massive dollar buying operation, probably at the order of one trillion dollars, to save the wholesale collapse of dollar and to prevent the destruction of the current globalization process.