The Future of the Carry Trade

The Japanese yen has been suffered the most in the wake of news that fewer Americans lost their jobs in November. There has been a debate in the market over what would happen when the dollar carry trade was exited. One camp thought the the end of the dollar carry trade would be marked by renewed crisis and the unwind of the risk trade. The other camp suspected the yen would replace the dollar as the key financing currency.

Consider the big picture developments this week. UK officials made some noises about perhaps selling some corporate bonds, ostensibly to boost liquidity, but the market sees it as another sign that quantitative easing policy is on its last leg. The ECB adopted an index rate to the 12-month refi operation and although Trichet said it did not signal anything about the trajectory of rates, the market realizes the only significance of the move it if the repo rate was hiked. And now the US jobs report and the revisions are more than even the most optimistic forecasters anticipated and as we previously noted, the market has brought forward the anticipated Fed hikes.

Japan offers the stark contrast. Monetary conditions were eased by the BOJ at the conclusion of their unscheduled meeting. A supplemental budget is expected to be unveiled early next week (perhaps Monday). Japanese officials have officially recognized that deflation will continue to grip the economy for beyond next year.

We have also noted that the net non-commercial position (speculators) was near historic extremes of long yen. If this is representative of the speculative community as a whole, which could be a big "if", then the first part of the yen's decline is likely more of long liquidation than shorting the yen.

Also to the extent that the dollar as a financing currency was also used to fund dollar denominated assets, then the yen may not be able to should the entire burden. For example, our understanding is that in 1999 European banks had roughly $2 trillion of US dollar assets and by the end of 2007, they had grown to $ 8 trillion. The yen is a poor alternative to the dollar for this kind of thing. To the extent investors borrowed dollars to by emerging markets, the yen might offer an alternative.

The other point to be made is in terms of gold. The recent performance of gold, both in reaction to the Dubai news last week and to the stronger US jobs data, strongly suggests gold is part of the risk trade not the safe haven some have suggested. As dollar carry trades unwind, gold suffers in dollar terms, but it is appreciating in yen terms.