The Yen "Carry Trade" Unraveling Saga: A Deja-Vu Nightmare and a Cautionary Tale... Nouriel Roubini | Feb 01, 2007
Let me tell you a cautionary tale for 2007. The Yen has been weak and has kept on depreciating sharply for the last few months relative to the US dollar. Still mixed and weak economic data are coming out of Japan and short term interest rates there are still 0.25% while they were closer to 5.5% in the US; so the yen is weak and weakening. Massive amounts of carry trades using the yen – and the swiss franc – as the funding currency have been going on for months now leading to sharp increases in leveraged positions by investors who have been shorting the yen to play the carry trade bet.
Then, the yen starts to appreciate again – by a sharp 9% in one month - when a small emerging market economy defaults (Ecuador soon?) and a large hedge fund goes belly up (another Amaranth?). Then, suddenly one piece of good news comes out of Japan (a growth pickup?) and in a matter of 72 hours the yen appreciates by 12%. Then a major global macro hedge fund loses $2 billion dollars in 48 hours on the yen unraveling and decides to close shop; another one loses billions too and decides to restructure its operations. Carry trades unravel rapidly, margin calls are triggered, levered positions go belly up and the entire financial system goes into a seizure. Then the Fed is forced to cut the Fed Funds rate in between meetings by 75bps (in spite of still good US GDP growth) in order to avoid a financial meltdown, a collapse of US financial markets and a global recession.
Readers of this blog may think that the first paragraph above describes very precisely the current situation of the yen and of the global financial system in the last year. Indeed, news reports have been endlessly talking about the yen carry trades driven by low Japanese interest rates. Readers of this blog may also think that the second paragraph above is a typical Roubini "doom & gloom" fear mongering and describing a scenario that is totally unlikely to occur in 2007.
But what I was describing in the first two paragraphs above is not 2006 and a fear mongering scenario for 2007 but rather what actually and exactly happened in August-October 1998. During the Asian crisis the yen weakened all the way to 147 to the US dollar by late August 1998; and the BoJ reduced its policy rate to 0.25% (the same level as today). Then in August 1998 Russia defaulted (this time around it may be Ecuador this month) and this default triggered a seizure of global financial markets as major players with levered position started to get margin calls, had to dump their assets to cover their margin calls and started to cover their yen carry trade shorts. LTCM then was hit by this liquidity seizure and avoided a near default in late September 1998 via a private sector bailout coordinated by the NY Fed.
In the month between the Russia default and the near LTCM default the yen went up from 147 to 134, a 9% appreciation as some of the carry trade were unwound when the hedge funds had to reduce their leveraged positions after the Russia losses. Then, on October 5th a minor piece of good news came out of Japan: the Japanese government came out with a plan to recapitalize its problem banks. This mildly yen-positive news led to an appreciation of the yen that was massive: in a matter of 72 hours the yen went from 134 to the dollar on October 5th to 118 to the dollar on October 8th, a whopping 12% increase. And on the peak day of the yen correction – October 6th - the dollar, the US equity market and the US bond market all fell rapidly on the same day.
The dollar/yen rout was triggered by the rush to the exits of all those who had shorted the yen and played the carry trade. They all massively tried to cover their shorts exacerbating the yen appreciation. Julian Robertson’s Tiger Fund lost $2 billion on the unraveling of that carry trade; and allegedly even other large macro hedge funds has massive losses. LTCM lost more money on that yen unraveling that then led to another liquidity seizure in US capital markets. Greenspan then declared that the world was facing a global credit crunch and worries about a world recession mounted; soon after the Fed reduced the Fed Funds rate by 75bps.
So this is what actually happened in 1998 and how the yen carry trades dramatically unraveled in a matter of 72 hours triggered by a real minor piece of news out of Japan.
Then, the relevant question from this 1998 cautionary tale becomes: could the yen carry trade unravel as fast today? The similarities to 1998 are amazing: massive carry trades on yen and other low yielding currencies like the Swiss franc; massive and increasing amounts of leverage as credit derivatives are creating a credit house of cards; complacency and mispricing of risk; rising Values at Risk and loosening of risk management standards; Ecuador on the verge of defaulting (ok Ecuador is not as systemically important as Russia - and Russia’s default was a surprise - but Russia in 1998 had a GDP of only $400b, the same as Netherlands).
And now everyone is starting to worry about a shock that would lead to the unraveling of the yen carry trades. As in 1998 every individual investors thought he or she was smart enough to be able to cover its yen shorts before everyone else did and before the yen moved too fast. But of course in equilibrium not everyone can get out of the same position at the same time without sharply moving market prices. When everyone rushes to the doors at the same time in a stampede lots of blood is spilled and the pain is massive; Tiger lost $2 billion in 48 hours; many more losses did occur on those yen carry trade unraveling.
And the lesson of 1998 is that it often takes a very small piece of news to unravel such carry trades. Today the conventional wisdom is that the yen carry trades will continue as long as the BoJ keeps rates at 0.25% or raises them slowly over the next few months; this conventional wisdom also argues that as long as macro news remain weak in Japan expectations of BoJ policy will not change much and the yen will remain weak. But the lesson of 1998 is that unchanged macro outlook and unchanged BoJ policies may still trigger a rapid unraveling of yen carry trade if some minor yen supportive news occurs.
When everyone is short on yen and doing the carry trade they are looking for some extraneous piece of news that becomes a focal point for covering such shorts. Then, any relevant news can become such focal point. And once can think of plenty of news of surprises that would lead investors en masse to start covering their yen shorts today. So, could what happened in 1998 happen again today?
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