Yen shock next market crisis
Fri Nov 9, 2007 1:18pm EST
By Mike Dolan - Analysis
LONDON (Reuters) - Just as renewed waves of forced asset sales and bank write-downs risk turning this year's credit market turmoil into a vicious circle, the Japanese yen looks set to deliver another shock to global markets.
An accelerating slide in the U.S. dollar (.DXY: Quote, Profile, Research) this week has been driven by a growing conviction that the U.S. Federal Reserve will be forced into further steep interest rate cuts.
And as dollar losses against the yen started to spiral on Friday, fears have risen of a mass unwinding of the yen "carry trade" -- currency trades funded by cheap, low interest rate yen and estimated to be worth up to $200 billion.
Sudden losses on these trades -- which thrive when currency market volatility is low -- could force speculative hedge funds to cut other market bets to fund those losses, and also reverse the flood of Japanese money invested overseas in recent years.
"The potential for a further carry unwind -- presuming we are now in a second wave of risk aversion -- is quite high now," said Michael Metcalfe, senior strategist at State Street.
"These waves of risk aversion are washing through markets one after the other and seem to be hitting the credit markets first, then equity markets and then the FX markets," added Metcalfe. "It's what happened in July and August and it seems to be what's happening again now."
THREE INJECTIONS
The global financial system supercharged historically low central bank interest rates in recent years in several ways but there were three powerful injections.
One was through repackaging bank loans into securities for sale to a wide range of investors, freeing up bank balance sheets to allow them to lend more. Those markets are now in meltdown after a U.S. mortgage market bust called into question valuations of these complex instruments.
The second was via leveraged buyouts by the likes of private equity firms, who used cheap credit to raise cash and pumped billions into stock markets via a wave of takeovers. The credit squeeze has put much of this activity on ice.
And the third amplifier was currency carry trades, with cheap yen financing at its core.
Now that too looks at risk.
ECHOES OF 1998?
The dollar set successive historic lows against the euro and 26-year lows against the British pound earlier this week.
But on Friday it lurched to an 18-month trough against the yen of 110.52 yen, breaking the stable 5-yen range it had held since the Fed discount rate cut in August reversed a flight from risky currency bets.
The lurch sent currency volatility measures haywire, forcing further closing of yen-funded positions in a self-feeding cycle.
BNP Paribas' currency volatility index surged to a near 3-month high of 9.6 pct on Friday, with implied one-month dollar/yen volatility soaring to more than 14 percent.
And that surge of more than six percentage points marks the biggest weekly rise in implied volatility since 1998 when the dollar tumbled 10 percent in a week after a Russian debt default and near-collapse of hedge fund Long Term Capital Management.
Volatility is simply an anathema to carry trades, which only make sense when there's seen to be a low risk that big currency swings will erase the interest rate pickup.
Hedge funds can borrow yen for three months at less than one percent annualized and put them on deposit in dollars or euros for about four percentage points more. That is a one-way bet as long as currency rates are stable.
But forward interest rate theory suggests that interest-rate differentials merely reflect a premium on the higher-yielding unit to compensate for the inherent risk of depreciation.
With the dollar now falling so sharply, the interest rate gain is being wiped out by exchange rate losses.
"Carry trades do not work in this sort on environment, they work in a low-volatility stable environment," said David Brickman, credit strategist at Lehman Brothers. "Therefore carry trades get unwound and dollar/yen has further to go."
HOW MUCH UNWINDS?
Policymakers have been fretting for over a year about the difficulties of estimating how much money might be caught up in a carry unwind -- not least because the money is a mix of speculative positions and Japanese capital seeking higher yields overseas.
Japan's top financial diplomat Hiroshi Watanabe earlier this year guessed investors might have borrowed between 10 and 20 trillion yen: at current exchange rates, anywhere up to $200 billion.
And the Bank for International Settlements in June warned that this was an accident waiting to happen.
"The underlying problem seems to be a too firm conviction on the part of investors that the yen will not be allowed to strengthen in any significant way," it said in a report.
"Investors might be better encouraged to consider the autumn of 1998, when the yen rose by more than 10 percent against the U.S. dollar in the space of two days, inflicting sizeable losses on those involved in the carry trade business."
