Currency strategists at Merrill Lynch believe the carry trade is in big trouble.
Unlike the carry trade unwinds and subsequent recoveries that took place in April 2006 and March 2007, Merrill Lynch believes ‘The factors that would drive a sustained unwinding in carry trades are now in play.’ These factors includes an increase in volatility, G10 policy rates moving above neutral, and monetary policy tightening by the low yielding countries.
Noting China’s surprise rate hike on 21 August, the bank says ‘This is significant because it suggest that the liquidity providers are willing to rein in monetary policy and, in our opinion, place carry trades under even more pressure, despite the current bout of volatility.’
Discussing the role of volatility, Merrill Lynch comments:
The BIS noted last year (“The recent behaviour of financial market volatility,” BIS papers no 29, August 2006) that the decline in volatility could be both structural and cyclical. The current rise in FX volatility, which started a few months ago, suggests that at least some of the cyclical decline is beginning to reverse. This is brought about by general factors such as the continued tightening cycles by central banks, but also the special factors associated with the sub-prime market.
The structure of the current bout of financial market stress, the losses associated with asset-backed securities and credit default products, are unique in that the holders of the distressed products are unknown. The diversity of the holders of the bad debt may in fact be beneficial in the long term, as the risk is not concentrated in any one institution, but in the shorter-term this generates uncertainty. The market does not know where, when or by whom the next announcement of losses and exposure is going to come from. In turn, this has led to the withdrawal of liquidity in many financial markets – displayed by the action in the US Treasury market, and a rise in risk aversion and volatility.
We believe that this uncertainty will continue over the coming months. In turn, this suggests that volatility remains elevated and places carry trades under continued pressure now. This is expected to prevent the recovery by carry trades to previous highs, in contrast to the last few carry unwind periods.
Turning specifically to the yen, Merrill Lynch sees scope for continued appreciation through to the year end:
The yen carry trades have been supported by the decline in JPY volatility to very low levels. We have previously shown … that a rise in volatility makes yen carry trades specifically less attractive on a volatility-adjusted interest rate spread basis. If we believe that volatility will remain high, then there should remain support for yen.
In addition, the narrowing of interest rate differentials also makes this less attractive. We previously found that it was not necessary to see rates in Japan above those in the US (for example), but a narrowing was all that was necessary for a strengthening in JPY. This narrowing is now occurring and should continue. We expect the BoJ to raise interest rates once more this year, and the Federal Reserve to cut rates.
Structured products, such as Power Reverse Dual Currency (PRDC) notes, which are ’similar to Uridashis – they raise funds by borrowing at yen interest rates and coupons are based on the exchange rate, eg, USD-JPY’, are also noted as a potential driver of JPY appreciation. The notes are structured such that:
At its extreme, as the yen appreciates, issuers must increase their holdings, leading to further currency appreciation. A rapid appreciation could thus cascade, in extreme situations, as the issuers become shorter gamma as spot declines.
However, ML do say ‘A caveat, however, is these notes have been issued since the late 1990s and it is argued that they did not play a significant part in the 2003-04 JPY move.’
Merrill Lynch concludes:
The current period of market turbulence has seen a partial unwinding in carry trades. We believe that the rise in volatility should prevent carry trades rebounding to previous highs, similar to the last few periods of unwind. There remains pressure on an unwind through to year end.
There are special factors which should support continued appreciation in the JPY. These include the volatility-adjusted interest rate spread, and the influence of Japanese structured products.
Source Cause & FX - ‘Carry, volatility and JPY in particular’, 29 August, 2007
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