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Carry Trade Comeback?

S&P 500 Index - USD/JPY

It was nearly 25 years ago in which the United States pleaded with the Japanese to strengthen their currency by intervening in the currency markets. The Plaza Accord was seen then as a measure to help the U.S. economy to emerge from a serious recession that began in the early 80's and alleviate the trade deficit with Japan. It failed miserably because the trade deficit was due to structural issues rather than monetary conditions. While this marked Japan's emergence as a real player in managing the international monetary system, the recessionary effects of the strengthened yen created an incentive for expansionary monetary policies that led to the Japanese asset price bubble of the late 80's.

As a result, since the mid-90's, the Bank of Japan has set interest rates at very low levels to fight deflationary affects of an ongoing multi-decade long recession. Due to Japan's export-dependent economy, in order to maintain a weaker currency, the Ministry of Finance intervened selling 35 trillion yen over a 15-month period up to March 2004. This birthed the infamous carry trade, in which investors borrowed at low interest rates in yen and used the proceeds to buy higher yielding assets. Conservative estimates valued the carry trade between $80 billion and $160 billion, but a better estimate of the size of the carry trade was the record of net short positions in yen futures on the Chicago Mercantile Exchange. This put the total size of the carry trade as high as $1 trillion before the so called "trade of the decade" began to unwind.

All good things must come to an end and in the early days of the financial crisis, the carry trade which had flourished is less volatile times began to unravel. As risk aversion increased in 2007, market volatility prompted traders to deleverage and sell their most profitable trades. Another factor that caused the unwinding of the carry trade was the shrinking interest rate differential between Japan and other economies. With most global economies in jeopardy due to the strain of the financial crisis, central banks were forced to cut interest rates. Although, the Bank of Japan had also lowered interest rates, the shrinking differential became too small for the carry trade to compensate against increasing losses as high-yielding assets began to weaken.

Even on the most conservative estimates, the yen's steep rally probably left carry-trading hedge funds with losses of $3.1 billion to $6.2 billion. While the trade-weighted yen remains near all-time highs, risk appetite seems to be making a comeback of sorts. In fact, this past month was the best September for equity markets in the last 70 years. The strong correlation between the S&P 500 and the USD/JPY, which began to decouple towards the end of 2009, looks to have been resolved according to a weekly correlation study (see chart above). This suggests that if equity markets continue to advance, the yen should revert to weakness.

While there are overwhelming expectations for global interest rates to remain low, as long as market volatility remains low there is some evidence that the yen carry trade could soon make a comeback. With Japan's recent commitment to weaken the yen, the USD/JPY is expected to remain well-bid ahead of the 83 handle. Since intervening two weeks ago, the trade-weighted yen has slowly grinded higher, doubling the amount of time it took to fall from recent highs. As such, a higher low for the USD/JPY is sought near current levels. Meanwhile, the long-term downtrend remains firmly intact while below the 85.87 level, the 25% retracement of the entire move off the 2010 high.

STRATEGY: BUY USD/JPY at current levels, risking 82.70, targeting 85.15


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