Posts from — June 2007

Yen-funded carry trades are not finished, despite reports to the contrary. To paraphrase Mark Twain, reports of its death have been greatly exaggerated. All three commodity currencies, the Australian dollar, the New Zealand dollar and the Canadian dollar, gained against the yen last night. High oil prices and bad Japanese economic data spurred the poor results. Even the US dollar was able to pick up value against the yen yesterday, despite the inaction by the Fed. The yen gains in the forex market earlier in the week now look like a bout of international risk aversion. But with the momentary blip over, yen shorting should resume with a vengeance.

There are many reasons for the current yen weakness. The data released earlier this week was fairly yen-positive. Retail Sales and some investor indices proved encouraging for yen bulls. But the name problem with the Japanese currency has always been the country’s battle with deflationary pressures. The interest rate has been so low for so long, and economic policy makers in Japan are powerless to raise interest rates until growth picks up and inflation returns to the economy.

But the last couple of reports coming out of Japan do not leave much hope for the country. On the growth front, Industrial Production fell 0.4% when most forex analysts were predicting a 0.9% gain. And even more damaging for those predicting an interest rate hike, the CPI report this morning showed a drop in prices of 0.1%. Before final decisions on the yen are made, there is still some data on tap, including overall household spending, the jobless rate and manufacturing PMI. But if deflation persists, the Bank of Japan cannot raise rates in July or August, further dooming the currency.

The yen is easily the most undervalued currency in the forex market, at least among the most highly traded currencies. It has lost 4.3% against the US dollar this quarter. That puts it on track for its biggest quarterly loss against the dollar since 2001. Most of that is due to the popularity of yen-funded carry trades, fueled by the low interest rates in Japan. The majority of currency analysts expect those carry trades to continue to outperform. With the growth and inflation outlook in Japan looking as dire as it does right now, it would be foolish to predict the end of the carry trade wave and the end of the yen slide.

As the yen fell from a two week high against the dollar and weakened versus the euro this morning, it is possible that the carry trade is back in action among traders. The yen dropped to 123.04 per dollar at 9:35 a.m. from yesterday’s price at 122.83. Against the euro, the Japanese currency fell from 165.24 to 165.77. The yen, with its remarkably low interest rate, can be borrowed and used to buy currencies with much higher interest rates. The difference in rates then allows for a sizeable profit with out the rate of exchange having to more a pip in either direction.

According to Nicholas Bennenbroek of Wells Fargo & Co, markets are back on track and investors have regained confidence in the carry trade. Reports on the U.S. economy have shown a 0.7 percent first quarter growth beating lower expectations. Furthermore, investors are expecting policymakers at the Federal Reserve to hold interest rates at 5.25 percent. The final Fed report is due today at 2:15 p.m.

Even though the signs point to a resurging carry trade, investors should be wary of long term goals by Japan’s Central Bank. As soon as the opportunity presents itself, the BoJ will raise interest rates immediately. Due to years of persistent deflation in the Japanese economy, policymakers have continually been forced keep low interest rates. Recent reports have in fact shown that core consumer prices have been steadily decreasing every month this year. Data reveals a fall of 0.1 percent since a year ago.

On the other hand, in favor of Japan’s Central Bank are yesterday’s figures which revealed an unexpected rise in retail sales. Japan’s retail sales rose for the first time in eight months increasing by 0.1 percent in May from a year ago. Furthermore, economists are expecting core prices in Tokyo to rise for the first time in five months. This could in fact be an inflationary start for Japan’s economy. As soon as Japan’s Central Bank gets a chance to increase interest rates, long run confidence in the carry trade will diminish immediately.

The United States Federal Reserve’s interest rate announcement and accompanying statement is scheduled to be released today at 2:15 PM Eastern Standard Time.  Barring a complete surprise, the Fed is likely to leave interest rates at 5.25% and issue a statement hawkish on inflation.  With contradictory data regarding economic growth and interest rates, the bank cannot do any more.  A move in either direction would prove harmful.

Economic growth in the United States is actually rather sluggish and does not bode well for the US dollar.  In today’s GDP report, we saw that the economy grew 0.7% in the first quarter of 2007, the slowest pace in four years.  This number was higher than the estimates last month of 0.6% but lower than the forecast of 0.8%.  The economy certainly is not growing at the pace it was last year, when the last quarter of 2006 registered growth of 2.5%.

Various sectors of the economy have felt the effects of the economic slowdown.  The housing market is undergoing it biggest slump in two decades.  Demand for housing seems to fall with every new report, and the sub prime woes have led to the number of foreclosures reaching record highs.  Consumer spending, which makes up the largest portion of the US economy, is cooling, mainly due to higher energy prices.  Its growth this quarter is half what it was last quarter.  Business investment is also falling, suggesting that the slow growth this quarter may not be an aberration.  Yesterday’s durable goods report showcased a larger than expected drop in May.

But even considering all this bad news, the FOMC cannot lower interest rates to stimulate the economy.  And the reason why is rising inflation.  Prices continue to rise, at a pace with which the Fed is certainly not comfortable.  Today’s numbers showed a 2.4% rise in core inflation, stripping out food and energy costs.  That is certainly discomforting to policy makers, especially compared to the 2.2% rise that was expected.  And when you consider that the Fed under Chairman Bernanke has professed to prefer inflation within a 1-2% range, you further get the sense that inflation is a big worry.  That is why interest rates are not likely to change, and the statement from the Fed is bound to be tough on inflation (Kathy Lien has a more detailed discussion of the Fed’s decision on interest rates).

What does the Fed’s announcement mean for the US dollar?  The cable should continue to rise, especially in anticipation of the likely interest rate hike in the next BoE meeting.  GBP/USD should not have much trouble staying above 2.000.  The euro should see some gains as well, with similar expectations on the interest rate decision of the ECB.  The yen is a little bit more interesting.  With core prices falling yesterday, the country’s battle with deflation is not yet over.  As long as the Fed remains consistently hawkish in its statement, we might see a reversal of yen gains against the dollar with USD/JPY testing 125.00 soon.

Both U.S. and European equities markets have taken a fall with the news of disappointing durable goods and weak new homes sales still fresh in trader’s minds. The European Dow Jones Stoxx 600 Index fell 0.8 percent to 386.38, the Euro Stoxx, decreased 0.8 percent, and both the U.S. Dow Jones Industrial and S&P 500 fell 0.4 percent.  

The fall in U.S. and European equity markets have pushed forex traders to buy Swiss francs. The franc has gained on the euro for the fourth straight day. Against the euro, the franc is up 0.2% to 1.649, the strongest since June 8^th. Diminishing confidence in the U.S. and European equities have sent investors are looking for security. As in the past, as general risk aversion increases, the Swiss franc gains in value as well as more investors are looking for a low risk investment. With a weakening of the European market, long euro positions have been liquidating and flooding the market for Swiss francs.

Other factors that have contributed to the rise in demand for Swiss francs include news of increasing borrowing rates by the Swiss National Bank. This increase in turn makes a currency more attractive in value as room for arbitrage is created against another currency with a relatively lower borrowing rate. The European Central Bank has also indicated a desire to further increase interest rates to combat inflation which will likely hurt their already weak equities market.

We might be seeing the beginning of a yen rally.  There are a number of factors that point to the unwinding of the carry trade and the subsequent rise of the Japanese yen.  Recent economic data suggests that consumer demand in the Japanese market is finally starting to pick up.  There are growing problems in alternative international financial markets, leaving less attractive options for carry traders.  Lastly, the words and actions of policy makers around the world point to a growing impatience with the forex carry trade.

The main weakness in the Japanese economy over the years (and the factor dragging down its currency) has been poor consumer demand.  That was the primary factor behind the Japanese recession and the multiple years of deflation.  And the failure of the consumer to rebound has prevented the Bank of Japan in recent years from raising interest rates, the primary driver of any currency.  But Japanese Retail Sales just went up 0.5% vs. 0.4% forecast.  This is only one piece of data, but signs point to a greater Japanese recovery.

Another development that does not bode well for forex traders in the carry trade is the downturn in international financial markets.  Equity markets in the United States, Europe and Asia have slowed down in the past week (see DailyFX.com for a take on how the transfer of power in London today will affect the forex market).  Also, greater risk aversion among traders has dampened enthusiasm for high-yielding emerging markets.  There is less possibility for easy growth world-wide, stemming the seemingly voracious appetite for Japanese yen borrowing.

Comments by central bankers have also helped to unwind the carry trade.  RBNZ Deputy Governor Grant Spencer has said that his bank is not done intervening in the forex market to push down the New Zealand dollar.  This is significant because the Kiwi has been a popular partner for the yen in the carry trade because of the 7.5% interest rate differential between the two countries.  Spencer is not the only one warning against the one way bet.  Japanese finance minister Koji Omi is also cautioning trader against relying on that phenomenon.  And Bloomberg has some good analysis on the carry trade effect of the resignation of Japanese finance minister for international affairs, Hiroshi Watanabe.

We have already seen empirical evidence that the Japanese yen is rebounding.  Yesterday, the yen gained against 15 of the 16 most actively traded currencies.  Only Norway’s krone performed better in the currency market than the yen.  As Japanese investors retreated from emerging markets and foreign equities, the yen benefited.  The currency had its biggest gains against the Australian and New Zealand dollar, but it also rose the most in 10 weeks against the euro and the US dollar.  As sub prime problems continue to haunt the US market, the yen is now at 122.42 per dollar and 164.60 per euro.

The Canadian dollar reached a 30 year high at 94.79 U.S. cents. Even though it has fallen since, an increase is still possible after today’s U.S. government report showed a decrease in new home sales 930,000 in April to 915,000 in May. New homes were sold at a median price of $236,100, down .9 percent from a year ago. Due to this decrease there has been reason to believe that the U.S. Federal Reserve will begin cutting interest rates causing investors to be prone to selling the U.S. dollar allowing the Canadian dollar to gain.

Further Canadian dollar gains are very possible, but it is important to be aware of the other factors affecting currency fluctuations. As Canada and the U.S. have a close trade relationship, a slowing U.S. economy could spill over into Canada resulting in a Canadian dollar could losing ground to major foreign currencies such as the euro and the pound.

Additional factors affecting the value of the Canadian dollar are crude oil prices and Central Bank lending rates. Crude oil prices have been declining and could hurt gains made from the U.S. housing report. Due to the fact that oil makes up half of Canada’s commodities exports, decreasing oil prices will hurt the Canadian economy. This in turn will make its currency less valuable. Lastly, there is still uncertainty as to whether the Canadian central bank will raise lending rates for its currency. On May 29^th this year, the central bank had announced a possible increase in rates because inflation was not at the target level. However, this change has not happened yet as the lending rate has continued to be at 4.25%, the same since May 2006. The Canadian dollar will see a short term gain with news of slowing new U.S. home sales, but it remains to be seen whether it can maintain this gain in the long term.

The market for emerging market currencies is entering an interesting phase. As I mentioned yesterday, global risk aversion is on the upswing. That would suggest a capital flight from emerging markets to more blue chip investments like the US dollar. But conversely, record commodity prices all over the world have boosted demand for these emerging market currencies to an extent that has not been seen in recent years.

To illustrate this dilemma, it’s important to understand what risk aversion does to forex demand in different parts of the world. US Treasury bonds have historically been some of the safer investments internationally. With the recent volatility in the foreign exchange market and the US equities market, demand for bonds has skyrocketed. Bond yields have dropped to 5.07%. Investors have bailed out of riskier investments, including high-yielding and emerging market currencies. Even when bond yields were at record highs a couple weeks ago, empirical data has shown that international central banks had not been the ones to start the sell-off.

But counteracting this flight to safety is the attractive of emerging markets. Brazil is a great example. The Brazilian real is at 1.905 per dollar, up 9.6% this year and 59% over the past three years. The real’s meteoric climb has been supported by a pair of factors. Record commodity prices in iron ore, orange juice and soybeans have led to record current account surpluses. Foreign investment in Brazilian stocks and bonds has led to record capital account surpluses. Most economists believe that the currency level will stay constant for the rest of the year. But there is some hope for short sellers as a vocal minority warns of a drop to 2.5 reals per dollar on the back of lower commodity prices.

The rest of Latin America is caught in a similar situation. Risk-averse investors are cashing out right now. But overall, the appetite for high yields is insatiable. High demand for commodities, from corn to copper to oil, continues to push currencies higher. But investors must proceed with caution. The market for emerging market currencies is relatively illiquid; meaning the risk for potential volatility is much higher.

Recent developments in world financial markets suggest an increase in international volatility.  As the carry trade thrives on financial stability and an increasing appetite for risk, an upward re-evaluation of that risk could slow down carry trades in the forex market.  The most prominent situation is the one regarding US dollar-denominated assets.  Recent economic data has actually surprised to the upside.  And this week’s housing data should be fairly positive as well.  But the dollar sank like a stone over the weekend.

The hedge fund shutdown at Bear Sterns has ignited fears of an industry-wide re-pricing of bonds that would prove catastrophic to financial institutions all over the country.  When you add to that the growing volatility in the US equity markets (alternating days of gains and losses), traders have to view the currency market with a little more doubt.  Yield is really all they care about, and most signs point to the Fed making a non-move with regard to interest rates.  If the US market continues in this vein, the pound (which just broke resistance at 2.000) and the euro should clean up against the dollar this week.

International volatility does not end at our shores.  Risk has also reached the New Zealand dollar.  Chances are likely that the RBNZ intervened in the forex market again late last Friday.  When the Kiwi falls 60 points against the dollar in that short a time, something fishy is up.  So far, traders have been willing to weather these drops, and the currency continues to rise.  The central bank may be running out of money, but its resolve has not weakened in the face of what it feels it an overvalued currency.

Faced with this kind of data, the risk appetite of forex traders is being tested.  The Japanese yen, which is ridiculously undervalued, actually rose against both the US dollar and the euro in weekend trading.  Traders are cashing in on their carry trades, spurred by a report from the Bank of International Settlements warning against the one-way bet against the Japanese currency.  Even the Chinese central bank is calling for higher interest rates.  In these days, the specter of 1998 looms large, but even that may only prove to be a temporary brake on the risk appetite of currency traders.

Recent developments in the foreign exchange market prove that it is not just interest rates that drive action in the currency market.  Expectations of future interest rates also matter.   The currencies with the greatest chance of higher short-term interest rates are the currencies receiving the most support from traders.  The few currencies with bad prospects for an interest rate hike are getting hammered, and that will continue as long as expectations stay the same.  Just look at the results in the last 24 hours.  The pound and the Aussie have been the best performers while the Japanese yen continues to sink.

Much of this kind of activity is indicative of a strong carry trade.  Economic policy makers in Japan have been clear in their refusal to raise rates, at least until there are stronger signs of consumer recovery in Japan.  And when the Bank of Japan does start raising the overnight lending rate, they have committed to doing it as gradually as possible.  Japan’s rates are low, and people (investors) are encouraged to seek higher yields.  The can find those higher yields in other currencies, in the US stock market (witness the steady resilience of the market to any drops) and in foreign bonds.

The carry trade is simply an interest rate differential story.  There is a concern as it becomes more popular because that makes it inherently riskier (see Bloomberg’s stories on Japanese and Hungarian housewives engaging in the carry trade and beating the market).  But until the carry trade bet becomes untenable (and that will happen at some point), forex traders continue to reap their gains and push the yen lower.  The euro is at its highest level ever again the yen.  AUD/JPY is at a 15 year high and USD/JPY is at a 4 year high.  And perhaps most interestingly, the New Zealand dollar, the currency with the highest yield, is back to the rarefied levels it occupied before the RBNZ intervention.  The bank would like to push it down again, but it is running out of funds.  And central bank interventions do not usually work anyway.  The bottom line is that as long as the global market stays calm, carry traders will profit on the interest rate differentials.  But world-wide inflation, political uncertainty, a slowdown in the United States or anything else that throws the forex market into flux will put a wet blanket on the carry trade.