Category Archives: Currency

Japanese Individuals Getting In on the Yen Carry Trade

The WSJ reports that Japanese individuals are engaging in the yen carry trade, too.

Now people such as Naomi Kashiwazaki, 29 years old, have joined the fray. She trades currencies from her small apartment in Tokyo’s suburbs. She started about a year and a half ago to supplement the income from her online store, which sells designer athletic shoes that are hard to find in Japan. In recent months, she has earned an average profit of $8,600 a month.

“I must say, I am addicted to this now,” she says.

Tens of thousands of other investors like her are doing the same thing. With Japanese interest rates hovering at a low 0.5%, they borrow big piles of yen cheaply and then invest it in currencies elsewhere, looking for higher returns. Ms. Kashiwazaki makes trades totaling $200,000 or so a day among several currencies, ranging from the U.S. dollar to the Swiss franc.

As the yen gyrated over the past week, traders such as these are believed to have played a major role in the volatility. Last week, the yen gained 3.5% against the dollar.

“Japanese individuals are doing essentially the same thing as hedge funds,” says Tohru Sasaki, chief foreign-exchange strategist at J.P. Morgan Chase Bank in Tokyo. “Together they are acting like an enormous hedge fund.”

A combination of technology, deregulation and low interest rates is enabling individual Japanese to use the same kind of investment techniques as the pros. Borrowing money to trade currencies has become so popular in Japan that individual traders — sitting at their computers in homes across the country — now trade tens of billions of dollars a day, according to some estimates.

J.P. Morgan strategist Mr. Sasaki estimates that in the months leading up to last week’s sharp movements, Japanese individuals some days held foreign currency valued at more than five trillion yen, or $43 billion. That is similar to his estimate for the amount of yen loans taken out by professional investors in order to speculate in foreign currencies.

I have written before about the significance of the yen carry trade. This article supports my argument by showing how widespread it has become.

The US Trade Deficit as a Source of Global Liquidity

I have discussed before the importance of the yen carry trade for pumping liquidity into financial markets worldwide. But the US trade deficit may be a far greater source of easy money. The entire yen carry trade is widely estimated to be worth $200 billion. Compare this to the US trade deficit which is running at $800 billion per year.

Since many Asian countries devalued their currencies in the late 90’s, it has been much cheaper for US consumers to buy goods and services from Asia rather than from domestic suppliers. Currently, the US imports almost double of what it exports. If Asian exporters were to use their US dollar proceeds from sales and exchange it for their own currencies, their currencies would rise in value against the US dollar until trade between the countries balanced.

Instead, Asian central banks are currently intervening in foreign exchange markets by purchasing dollars from exporters at a rate that significantly undervalues the domestic currency. In effect, more domestic currency is being printed and traded for each dollar exporters earn than would have been the case had the foreign exchange market been more flexible. This causes the money supply in Asian countries to expand at a much faster pace.

Asian central banks use the dollars they have received to buy US-denominated assets, particularly debt. This has put downward pressure on US interest rates and stimulated greater lending, thereby increasing the money supply in the US as well. Much of the borrowed money is spent by US consumers to purchase more goods from Asia, resulting in a continuous cycle of money creation. Greater liquidity in Asia and the US spills over into other regions of the world via investments and trade causing liquidity to rise everywhere.

I outlined the effects of a potential unwinding of the yen carry trade in strengthening the yen, and weakening all other currencies and assets worldwide such as equities, real estate, commodities, gold, art, etc.

The unwinding of the US trade deficit will cause the US dollar to depreciate relative to Asian currencies such as the renminbi and yen. Also, declining liquidity will cause asset prices to fall. However, the US dollar gold price should do very well due of its inverse relationship to the US dollar.

What will cause an unwinding of the US trade deficit? One possibility is a slow down in US consumption arising from a collapse of the housing market. A robust housing market was integral to the economic recovery since 2002 creating employment and allowing households to cash-out their rising home equities. However, housing starts and home prices have been falling in the last year. This will eventually negatively impact the employment market and mortgage equity withdrawals causing consumption to decline, too.

Another possibility is Asian central banks, namely China, reducing their US dollar purchases in response to intense pressure from Washington. US interest rates would rise as a result, making it difficult for a debt-ridden US consumer to stay solvent.

I want to add that although I am forecasting global monetary deflation in the near-term, I believe inflation will prevail in the long-run. Central banks will be forced to combat any sort illiquidity by running the money printing presses at full steam leading to a period of stagflation. In the mean time, however, be prepared for tighter money.

Buying the Yen ETF

In my previous post I mentioned that I was sitting on 20% cash. Today I decided to use almost all of that cash to buy the CurrencyShares Japanese Yen Trust (NYSE:FXY) for $82.75 per share. In effect, I am still in cash — albeit yen rather that dollars.

My motivation for this trade is that I believe the yen carry trade will soon end, which will cause the yen to appreciate against most currencies. Last year, the yen was one of the worst performing currencies in the world. This year it could be the best.


As a contrarian, I am also delighted to see that there is a record speculative short position in the yen.


It should be noted that, unlike the other CurrencyShares, the Japanese Yen Trust currently doesn’t pay any dividends because Japanese interest rates are barely able to cover the trust’s expense ratio. But I believe a rise in the yen will more than make up for this shortcoming.

Yen Carry Trade Could End in 2007

The yen carry trade has been a major source of global liquidity since 2001 when Japan’s central bank cut rates to nearly zero while managing the US dollar-yen exchange rate. It’s intention was to stimulate Japan’s consumer spending and exports.

This policy allowed financial institutions to borrow funds from Japan and invest in assets offering higher returns such as emerging market equities and US bonds. For example, a hedge fund could borrow $100 million from Japan at 0.4% interest and use leverage to buy $1 billion short-term US treasury bonds yielding 5%. After one year, the hedge fund could close the bond position with $150 million. After paying off the loan in Japan it’s net profit would be close to $50 million and it would have earned a 50% return.

This assumes that Japanese interest rates don’t go up and the yen doesn’t appreciate. On January 18, the Bank of Japan decided not to raise rates and keep its key short-term rate at just 0.25%. With no signs that interest rates will rise anytime soon, the carry trade has picked up steam. According to a January 26 report by Barclays Capital the magnitude of yen-funded carry trades “is reaching scary levels” not seen since 1998.

Also, speculative short positions in the yen are at record levels:


Being a contrarian, I suspect that the yen carry trade will still reverse in the near future. Although Japanese interest rates may not rise, the carry trade could become unprofitable if the yen started to appreciate against other currencies. This is possible if Japan’s economy strengthens leading to greater corporate profits and rising equity prices. Then the Japanese stock market, which was one of the wost performing stock markets last year, would begin to out-perform global assets. This would cause capital to return to Japan and the yen to appreciate.

Another possibility is that the weakness in the US housing market causes consumer spending to taper off and the economy to slow down. In response, the Fed would cut rates which would cause inflation to accelerate and the bond market to decline. The US dollar would weaken making a major portion of carry trades that borrow yen to invest in US bonds unprofitable. Hedge funds would then be forced to cut losses and return the capital to Japan causing the yen to appreciate further. This would lead to a reversal of carry trades that invest in assets in other parts of the world. In the end, global asset prices could plummet.

Of course sudden and unexpected non-economic events could also blow up the yen carry trade. Possible triggers include an escalation in Middle East tensions, major terrorist attacks or a bird-flu pandemic.

Last spring the world got a taste of how bad asset markets could falter when the Bank of Japan announced its intention to abandon the zero interest rate policy. The yen appreciated against the US dollar by 8% during April and mid-May. Hedge funds began to unwind the carry trade in May and the ensuing sell-off in asset prices continued through mid-June. The S&P 500 fell by 5%, Japan’s Nikkei fell by 17%, most emerging markets’ equities fell by 20-30%, gold fell by 22%, and copper fell by 21%.

In late 1998 Russia’s debt default accelerated the implosion of Long-Term Capital Management LP and caused a panic in markets. Investors scaling back their carry-trade positions drove the yen up 20 percent in less than two months.

The best way to play this is to go long yen. Since I don’t trade futures I intend to simply sit on the sidelines and watch as asset prices fall. Hopefully, gold will also correct which would present an opportunity to buy some of my favorite gold stocks cheaper than today.

Should China Be Worried About Inflation

During 2006 China’s GDP grew by 10.7% vs. 10.4% in 2005. As I have discussed previously, China will continue to experience hyper-growth as long as US consumer spending does not falter. However, this looks like a low probability scenario given that the US housing market, which played a large part in boosting consumer spending during the last 5 years, is clearly in a recession.

Another cause of concern for China’s policy makers is the recent increase in inflation. Although the government reported that inflation increased by only 1.5% during 2006, December saw inflation rising 2.8% year-on-year. It is important to keep in mind that China’s government is similar to the US’ in constructing the CPI as a measure of inflation with a bias to understate. So actual inflation is likely to be even higher.

Asset prices have sky-rocketed as can be seen in the real estate and stock markets. Also, wages are increasing over 10% annually. The one sector which has been immune to inflation is manufactured goods due to increasing capital investments leading to economies of scale. But this can’t go on forever and continued cost savings will most likely end when US consumers reduce purchases of Chinese goods leaving manufacturers with excess capacity.

Rising inflation is inevitable due to China’s current policy of pegging the yuan to the US dollar. This has forced the central bank to recycle export earnings from dollars and other hard currencies into yuan leading to a blowout of the money supply which will eventually cause prices to rise. In December M2 increased by 17% year-on-year, much faster than GDP growth.

The central bank is trying to combat monetary inflation by selling bonds to commercial banks and mopping up some of the liquidity. In the long-run, this is ineffective and actually counter-productive since it will cause an increase in interest rates leading to further foreign capital inflows and monetary expansion.

There is only one way out of the inflation problem for China. The yuan must be allowed to trade more freely at a higher value, which would reduce capital inflows and credit expansion. Intense pressure by Chinese manufacturers, who have benefited from the undervalued yuan, has caused policy makers to contain the rate of the currency’s appreciation.

It is certain that the yuan will trade at a much higher exchange rate against the US dollar and Euro a few years from now. However, it is less certain that the appreciation will occur before China’s inflation gets out of control.

Yuan Appreciation Accelerating

Since September when I speculated that a yuan revaluation was imminent, China’s currency has appreciated by 1% or at an annual rate of 4% against the US dollar. However, the current rate of 7.82 yuan/dollar is still too high and has done nothing to reduce the China-US trade balance.

A high-level delegation to Beijing from the United States led by US Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke will meet with their mainland counterparts Thursday for two days of talks aimed at resolving trade disputes.

There is no doubt that China will face additional pressure to increase the pace of the yuan’s appreciation. China is hesitant to allow its currency to float more freely due to the pain that it would cause to its export sector and the inability for its capital markets to manage a more flexible yuan. Instead China would prefer seeing its currency rise gradually at 5% or so a year giving ample time for exporters to adjust to a stronger yuan and for additional reforms to be carried out in the financial sector.

The problem is that the US will not be patient enough to wait for the yuan to gradually appreciate, while its trade deficit remains high. You can bet that the US will retaliate with significant tariffs on Chinese goods if this is the case. This would be the worst situation for China since its export-led economy would struggle. If instead China revalues its currency by the tariff rate, then it could combat weakness in exporting with lower import prices and less US dollar reserves buying which could be used to stimulate the economy.

Therefore, I expect that the yuan’s appreciation that we have witnessed in recent months to pick up through a faster crawl and/or by a surprise revaluation announcement. My forecast is that the US dollar will be trading at less than 7 yuan by the end of 2007.

Gulf Countries and Their Surging U.S. Dollar Assets

When we think of countries that are hoarding US dollar assets the first country that pops to mind is China. But the increase in oil revenues in recent years has made the Gulf countries perhaps just as important in this regard. According to the Economist:

Counting only the Middle East oil exporters, the surplus has surged from $30 billion in 2002 to an estimated $280 billion this year. One reason why this gets much less attention than the smaller $160 billion increase in China is that only a fraction of it has gone into official reserves, which are publicly reported. Most of it is stashed in government oil-stabilisation or investment funds, such as the Abu Dhabi Investment Authority, which are much more secretive than the People’s Bank of China—but which probably hold just as many dollar assets.


The six members of the Gulf Co-operation Council, or GCC (Saudi Arabia, United Arab Emirates, Kuwait, Bahrain, Oman and Qatar) have fixed their exchange rates to the US dollar. As a result, they are unable to increase interest rates above the rate of inflation and cool down their over-heated economies.

As the Economist points out “only 10% of the GCC’s imports come from America (compared with one-third each from Europe and Asia), so from a trade-weighted point of view, the dollar peg makes no sense.” A more sensible approach would be to peg to a basket of currencies including the US dollar, Euro, several Asian currencies and gold.

Indeed the GCC is already moving towards this direction with the planned introduction of a new unified currency in 2010. Once established, the GCC leadership may decide to invoice their hydrocarbon sales in the new common currency, moving away from the current dollar pricing system. It could also become the reserve currency of choice for Islamic and Arab central banks for a combination of religious and political reasons.

All this could have severe ramifications for the US dollar. Currently, Asian central banks and Gulf countries are the major buyers of the US dollar. Any sort of reduction in this buying could cause the US dollar to tumble.