Carry Trade Momentum Grows

The yen carry trade remains strong in the foreign exchange market, but before analyzing why that is the case, let’s look at some specific exchange rates.  The US dollar has fallen in recent trading versus the euro (EUR/USD) and the pound (GBP/USD).  Bond yield in the US have declined from their record highs.  Home builder confidence is at its lowest in sixteen years.  And the CPI numbers last week (with core prices rising only 0.1%) demonstrate the slowing pace of inflation.  Put those factors together, and you get weak support under the dollar.

The pound and the euro, however, continue to receive strong bids in the currency market.  Much of this has to do with a growing consensus among traders concerning the likelihood of a rate hike by both the ECB and the BoE.  President Trichet of the ECB recently came out and said the new emergence of many fast-growing economies around the world is creating a upward pressure on prices.  These hawkish comments were coupled with remarks by other ECB members asserting the ability of other European economies to withstand a future rate hike.

The flipside of this strength is the persistent weakness of the Japanese yen.  There is optimism among Japanese policymakers (after the GDP and Industrial Production data), but the growth is still not robust enough to survive higher interest rates.  This is especially true with regard to the Japanese consumer.  And the low interest rates in Japan prove irresistible to carry traders.

Take the EUR/JPY pair.  It hit an all-time high of 166.12 yesterday eventually settling at 165.91.  The euro-yen has been a one way bet recently, and the tame US inflation reports will keep it that way.  The carry trades are unlikely to be interrupted in the near future considering the low risk of global inflation in the current currency market.  The US inflation data signals lower volatility in international exchange rates in the future.  So traders have more confidence that they can capture the differences in yields in two countries without the risk of losing those gains thorough market swings in the exchange rates.

But there is one important caveat for enthusiastic carry trades.  BoJ governor Fukui has said that it is important for the country to raise real interest rates to help domestic pension plans.  There is also a concern for political repercussions in Europe and the United States if the continuing devaluation of the yen proves to be too much of an advantage to Japanese exporters.  Lastly, 10 year bond yields in Japan have reached 1.935%.  Yield levels of 2.00% or higher could lead to a return to the domestic bond market for Japanese institutional investors.  That by itself could push the Japanese currency up, destroying carry trades.