Currency & Gold Update (Nov. 12, 2005): Yen carry trade

The exchange rate of dollar vs. yen has broken out of the trading range of 100 to 115 yen and has hit 118 yen level. As the short-term interest rate in US rises steadily, it has finally pushed the long-term interest rates to rise with it. This creates a perfect condition for yen carry trades, that is, to borrow yens at near zero interest rate, sell those borrowed yens for dollars, and use the dollars to buy higher yielding dollar denominated securities. Yen carry trades are favorite activities of highly leveraged hedge funds that undertake transactions many times the size of their own capitals. Yen carry trades can boost the value of dollar vs. yen quickly. The biggest enemy of yen carry trades is the strengthening yen. Since a yen carry trade only leaps the profit from the yield difference between dollar denominated debt instruments and the borrowing cost of yen, the profit margin is counted in a few percentage points. A slight move up of yen vs. dollar can quickly turn a yen carry trade into a loss. Thus when yen strengthens vs. dollar by a reasonable amount, all the yen carry traders will rush to unwind their carry trades, creating a sudden down draft of dollar. We should expect a period of heightened volatility in the value of dollar vs. yen. Euro had hit a bottom of 1.19 dollar when yen surged above 115 yen/dollar level. Then suddenly euro has broken through this 1.19 line and hit 1.17. This is due to the escalating riots in France. Since the short-term interest rate in Europe is about 2 %, not like 0 % in Japan, the possibility of Euro carry trade is slim; the volatility in euro should be less than yen. Nevertheless euro will move more or less in synchronization with yen, and the value of euro will be suppressed as long as the yield gap between US and Japan is continuing to widen.

The determination of the exchange rate of dollar can be simplified to the following scheme: Let us draw a large circle surrounding a smaller circle. The smaller circle represents dollars and yens in the currency market ready to be traded. The area between the larger circle and the small circle represent the vast reserves of dollars and yens that usually are not to be traded in the currency market. There are always flows of dollar between the reserves and the currency market. When dollars flow into the currency market, it becomes extra supply of dollar to be sold for yen. When dollars flow from the currency market to the reserve, it becomes extra demand of dollar against yen. If a net supply of dollar occurs, the value of dollar vs. yen will drop to a level that new outflow of dollar to the reserve will be induced to cancel out the net extra supply of dollar, or enough yen will be induced to flow in to stabilize the exchange rate. When dollars flow out of the currency market into the reserve, the price of dollar rises to a point that enough dollar will be attracted to the currency market from the reserve to cancel out the outflow of dollars, or matching amount of yen will flow out of the currency market to stabilize the exchange rate. The biggest factor of supply of dollars is US trade deficit. The direct US trade deficit with Japan causes a substantial amount of dollar to flow into the currency market of dollar-yen. However, there are other routes related to US trade deficit that will also cause dollar to flow into the currency market. For example, US runs a huge trade deficit against China, China runs a substantial trade deficit against Taiwan, and Taiwan runs a large trade deficit against Japan. Thus a portion of dollar flowed into the hands of Chinese exporters will go through Taiwan and eventually flow into the dollar-yen currency market. The demand of dollar vs. yen is created by the Japanese government's dollar buying operation, and is also induced by the widening yield gap between US and Japan. The above-mentioned yen carry trade is a good example of the induced type of dollar demand. The supply of dollar from trade deficit has been discussed throughout this website, and we have nothing to add here, but it is rather instructive to see the picture from the demand side of the equation.

In the figure at right, quarterly averages of yen/dollar are plotted as black dots, euro/dollar as red dots, and the real federal fund's rate as blue dots; the price index used to adjust GDP is used to calculate the real federal fund's rate. The quarterly data of the figure starts from the first quarter of 1980 up to the most recent quarter. High real interest rates in the early part of 1980's had pushed up the value of dollar. The fall of the real interest rate in US from 1984, combined with the desire of governments to see a weaker dollar in the 1985 Plaza accord, pushed the value of dollar down steadily until 1988. This sharp drop of dollar finally caused US trade deficit to turn around in 1987 and subsequently the stock market crashed. Waiting for the dust of the stock market crash to settle and seeing continued rapid expansion of GDP (see Comment 25 for the reason why economic slow down did not follow the 1987 crash and the shrinkage of US trade deficit immediately), the real interest rate was raised in 1988, causing dollar to stage a mini rally vs. yen and euro. When the economic slow down finally began in 1989, real interest rate was dropped until 1993, causing dollar to weaken anew, especially against yen. The fall of dollar was getting out of hand by 1993 due to the renewed expansion of US trade deficit against Japan, so the real interest rate was raised rapidly and Japanese government stepped into the currency market to buy up dollars. However, those measures failed to stop the falling dollar. It was the super low interest rate policy of Japan, installed in the middle of 1995, which turned around the value of dollar vs. yen by unleashing massive amount of yen carry trades. The rapidly rising dollar induced by yen carry trades soon sucked in Japanese yen in the hands of Japanese institutions and induced them to be converted to dollar to earn both higher yields and capital gains. Thus dollar caught fire and rose close to 150 yen/dollar by 1998. This sharp run up of dollar wrecked economies of many countries that were pegging their currencies to dollar (see Article 1 for a detailed account of the crisis). First to go were S. Korea, Thailand, Philippine and Indonesia, triggering the Asian economic crisis. The chain reaction reached Russia in 1998, forcing US and Japan to abandon the strong dollar policy and to stop the rise of dollar by joint intervention in the currency market to sell dollar and buy yen. This triggered the exodus of yen carry trades, and dollar plummeted sharply. By the summer of 1999 the chain reaction of strong dollar policy reached Mexico, causing another sharp drop of dollar. The sharp drop of dollar starting at 1998 shrank US trade deficit in 2000, burst the stock market bubble and ushered in another economic slow down. During the period of 1995 through 2000, real interest rate was holding at a steady, but high level. This means that the condition to engage yen carry trades had persisted. Thus after the gyration down of dollar had stopped at the end of 1999 dollar started to rise anew. When the economic slow down foreshadowed by the 1998-dollar collapse set in, FED started to lower interest rate aggressively in 2001, causing the real interest rate to plummet. It took a while for this message to seep into the currency market, and dollar started its long slide starting from 2002. This fall of dollar was arrested by the 400 billion dollar buying spree of Japanese government. Japanese government's massive dollar buying operation had in turn initiated a public rebut in a bizarre fashion (see the incident of Golgo 13 outlined in Article 8 for details). It looks like further help from Japanese government to support dollar through massive dollar buying will be difficult considering domestic suspicion within Japan; next round probably requires Japanese government to buy up near 1 trillion dollars, considering the exponential escalation of the amount of dollar bought up in Japan's successive currency market interventions. It is rather interesting to observe that the recent stretch of FED interest rate rising activity has started not long after that massive Japanese intervention and the Golgo 13 incident, as if FED now must shoulder the burden to defend dollar by interest movements instead of relying solely on Japan's currency market intervention. When the real interest rate has started to rise in 2004, and the road for yen carry trades is paved, dollar has started to rise again.

The real federal fund's rate is still close to zero at present, and has more room to rise. This means that the interest rate in US will continue to rise, and thus the rise of dollar may gather further momentum from the escalating yen carry trades. Currently only Chinese Yuan is more or less pegged to dollar. Considering the currency regime adopted by China at the end of July, yuan has room to fall against dollar if dollar continues to rise vs. yen and euro. However, if yuan moves down against dollar, the political pressure from US Congress will be intolerable, so we expect yuan will not fall against dollar even as dollar rises further, eroding China's competitive edge somewhat against other developing countries the currencies of that will certainly to fall along with yen and euro against dollar. This means that as dollar is pushed up by yen carry trades there will be no disruptive events like Asian economic crisis in sight, very different from the case of 1995 to 1998. This also means that dollar can rise for quite a while without the need to disrupt its advance. It should be noted that even FED stops the rise of interest rate soon, the yield gap between dollar and yen will be maintained unless Bank of Japan also rises interest rates by more than 1 percentage point. If the yield gap between US and Japan does not narrow, dollar will continue to rise in 2006. However, the persistently rising dollar will induce an even more rapid expansion of US trade deficit down the road. Eventually the supply of dollar from the trade deficit will catch up with the demand of dollar from yen carry trades, dollar will start to fall, and that will prompt the mass exodus of yen carry trades and a sharply lower dollar. If Chinese yuan is also pushed up significantly against dollar at the time when dollar falls sharply against yen and euro, US trade deficit will shrink with roughly 2 year lagging time, and a new recession will follow.