The Carry Trade & Why Japan Loves a Weak Yen

Features - February 1st, 2008
Yen

by Steven Collins, President of FX FOR JAPAN

If you have read the financial newspapers, or paid any attention at all to the fluctuations of the yen over the last year or two, it’s likely that you have heard of the “carry trade”. Perhaps in terms of its impact on global financial markets, or more likely in relation to the housewife that was reprimanded for not paying taxes on the several billion yen she made over three years in the foreign currency (FX or Forex) markets. Most foreigners in Japan will, by default, have some experience with foreign exchange, though probably not in terms of an additional tool in their investment portfolio.

The term “carry trade”, in Forex terms, simply refers to an investment strategy in which investors sell lowyielding currencies (currencies of countries with low interest rates, like Japan) and buy high-yielding ones (currencies of countries with high interest rates, like Australia, New Zealand, and South Africa). In this way they can borrow at a low interest rate and earn a high one. Since Japanese banks generally pay less than 0.5 percent interest per year, this makes for an attractive strategy for many residents of Japan. Should the yen weaken, the value of those Australian/New Zealand/South African currencies vis-à-vis the yen goes up, and investors make a trading profit on top of the interest they are earning. But wait, it gets even better. By using a little thing (with a big risk component) called leverage, clients can earn interest on many multiples of their investment, in some cases up to 200 times. This means a ¥100,000 investment can earn, in interest alone, around ¥2,800* every day! While using 200 times leverage is not considered wise, even at a more reasonable 50 times you can put your domestic account interest to shame.

‘Too good to be true?’ you ask. For the last few years, not really. However, in 2007 a fly appeared in the financial ointment. As long as the yen remains stable or weakens, the FX carry trade works well. You buy your Kiwi dollars for yen and sit back collecting interest and watching those dollars buy you more and more yen as more and more people do the same thing. The problem comes when the yen strengthens. This occurred in February 2007 when the Bank of Japan raised interest rates for a second time, after five years of holding them at zero, and then again in August when the US sub-prime debacle started to unfold.

What happened is that some very rational investors decided the US economy and its green representative, the US dollar, were having some serious problems and perhaps it would be a good time to sell those US dollar investments and buy back their borrowed yen. This in turn strengthens the yen, which is bad for all the people with those Kiwi dollars that are beginning to buy less and less yen. This then causes these investors to sell them along with the US/Australian/South African dollars to buy even more yen before all those “easy” profits disappear and the cycle becomes vicious. In financial markets there is rarely an orderly queue for the exit.

So what’s an investor to do?

Most importantly, do your best to recognize the opportunities and risks for what they are. This applies anytime you are laying down your hard-earned money in the hope it will find fertile ground and grow.

FX trading may seem a bit complex at first glance, all those charts, numbers and strange jargon like pips, ticks, and exotics, but it is essentially like trading in stocks, funds, property or, for that matter, tuna in Tsukiji. The goal is to buy at a lower price than you sell. A country’s currency fundamentally should, and over time does, reflect the health of that nation’s economy. Japan has been sick for quite some time but is stable and improving slowly…albeit very slowly. Chances are that the interest rates here will remain far below that of other countries for some time yet and as long as that is the case, the carry trade will be a strategy worth considering.

Forex has several important differences compared with those other investments—leverage, 24hr trading, small or even no commissions, multiple order types, automatic trade settlement to protect clients from excessive losses and more. It is these differences that have led to the rise and current fall of the carry trade, yet also allow millions of people around the globe to actively participate in what is, by far, the largest market in the world.

With education, diligence and discipline (controlling the greed urge) foreign exchange can be a lucrative investment for those with the risk appetite. Just don’t forget to pay taxes on your profits or you could wind up in the news yourself.

*based on prices at time article was written.