Carry Trade Unwind

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.