No More Carry Trading
Borrowing low interest currencies and investing in higher interest currencies is called carry trading. It used to be the simple strategy of FX trading. Japanese Yen was the most popular currency to borrow since its interest rate was near zero percent. Many investors sold Japanese Yen against the US Dollar, which is a higher interest currency, or bought the US Dollar against Japanese Yen, to make a profit by the interest-rate differential (spread). Carry trading is the major reason the JPY/USD rate hiked up from 101.77 on January 9, 2005 to 124.12 on June 17, 2007.
However, on August 16 and 17, 2006, with a growing sense of anxiety over the sub prime mortgage issue, the US Dollar dropped from 116.65 to 112 and it reached 111.58 once. There hadn’t been this large of a drop for a long time, and since, the Japanese Yen has been strong and the US Dollar has been sold (Interbank FX).
Stronger Japanese Yen & Weaker US Dollar
The US Dollar has always been a strong world currency, and many economists have presented a rosy picture of the U.S. economy. However, since the large drop of the US Dollar against the Japanese Yen, the trend continues. Carry trading depends on an inexpensive Japanese Yen, so this change has brought on the end of carry trading (Global Guru). Some reasons the US Dollar got weaker and the Japanese Yen got stronger are:
S. Sub prime mortgage crisis
Japanese Yen’s interest rate hike and US Dollar’s interest rate reduction
U.S. Sub Prime Mortgage Crisis
Beginning in late 2006, the U.S. sub prime mortgage industry declined, causing many sub prime mortgage lenders to fail or file for bankruptcy. On August 15, 2007, concerns about the sub prime industry caused a large drop in the stock market (Wikipedia). Although the U.S. market recovered those losses within 2 days, investors could not erase fears within the U.S. economy. Therefore, investors thought the US Dollar declined in value and started selling the US Dollar against the Japanese Yen. In addition, in response to anxiety about the market, investors made “flight to quality,” which means quitting risky trading and investing in safer products.
Usually, if there is “flight to quality”, investors sell stocks or company bonds and buy government bonds that are said to be safer. When bonds are bought, the bond market price hikes and yield rates go down. This makes the US Dollar’s interest rate lower since the interest rates are based on the yield.
Japanese Yen’s interest rate hike / US Dollar’s interest rate reduction
With the lower interest rate of the US Dollar, there is no point buying and holding it. Therefore, investors worldwide started shorting (selling) the US Dollar and started buying Japanese Yen. Also, it has been rumored that the Bank of Japan will raise the Japanese interest rate in the near future. Many investors think they should own the Japanese Yen when it is cheaper. On the other hand, there were some rumors that the Federal Reserve System (FRB) would reduce the U.S. interest rate. In fact, FRB reduced it significantly – 0.50% of the U.S. interest rate on September 19, 2007 (Yahoo! News). With the Japanese interest rate’s hike and U.S. interest rate’s reduction, the spread between those interest rates became smaller so carry trading is no longer an appealing strategy.
Value of Japanese Yen
What is the value of the currency? Most of the time, currency is evaluated by its interest rate. Therefore, higher interest rate currency is favorable for investment. Also, the country’s economic strength factors into the value of the currency. The Economist’s Big Mac index suggests that Japanese Yen is undervalued against other currencies (Economist). Even though the Japanese economy is strong, the value of the Japanese Yen is weak because of the lower interest rate and carry trading. Since other countries believe it is not fair for other countries (for example, if Japanese Yen is cheaper, Japanese cars can be unreasonably cheap so no one wants to buy American cars, etc.), the BOJ (Bank of Japan) believes they should raise the interest rate. Mr. Bruno Lettich, Managing Director of Fixed Income Trading at Merrill Lynch, says, “BOJ will raise the Japanese interest rate very soon, and Japanese Yen will be stronger. This is the end of the carry trading trend. USD/JPY rate can be lower than 105 or lower.”
Recommendation and Trading Idea
Although FRB’s Chairman Ben Bernanke and President Bush often make positive comments about the U.S. Economy, investors can’t shake the fear of insecurity of U.S. markets. As shown above, there is a strong trend that the US Dollar will weaken and the Japanese Yen will increase in value. My recommendation:
Stop carry trading;
Sell the US Dollar against the Japanese Yen;
Buy the Japanese Yen against the US Dollar; and
Buy Put Option of USD/JPY.
Carry trading used to be enticing since it was a very simple and easy strategy, expecting return with a lower risk. However, the USD/JPY rate will decrease in the near future so buying the Japanese Yen is recommended. Moreover, regarding Currency Option trading, buying put option of USD/JPY should produce a profit when the Japanese Yen strengthens.