Jesper Koll and the Carry Trade

From Forbes:

A Meltdown From The Yen-Carry Trade?

Global markets got totally spooked in May 2006 when the Bank of Japan withdrew excess liquidity by 12.2 trillion yen--equivalent to the Fed taking $200 billion out of excess U.S. liquidity.

This inexplicably oafish move by the Japanese government caused an instant implosion. Stocks, commodities and markets everywhere collapsed as everyone ran for cover. A reduction in global liquidity on this scale panicked the hedge funds, the mutual funds, everyone. Emerging markets like India gave up 30% in a month. U.S. stocks fell. Gold and oil retreated fast.

Why the panic? It looked as if the Bank of Japan wanted to push up the value of the yen and warn investors not to count any longer on borrowing cheap yen and putting it to work without risk in higher-yielding securities denominated in other currencies. In other words, stop the so-called yen-carry trade in its tracks.

Putting a crimp in the yen-carry trade would mean that everyone would have to move fast to cover his short positions. All it took was a move of over 5% in the yen, and the yen-carry trade would become a losing proposition. Many bankers think it's a ridiculously risky gamble anyway.

Somehow the Bank of Japan woke up to the panic it had triggered and began to put back into the global monetary system a portion of its excess liquidity.

You may remember that traders breathed a sigh of relief, and between July and October 2006 most global markets retraced their steps back to the old highs and then even further.

Merrill Lynch estimates that about $1 trillion worth of yen is being borrowed and then turned into higher-yielding investments. It looks like a sure thing. You borrow yen in Tokyo at 0.5% and use the money to buy U.S. Treasuries yielding 5%. Sounds like shooting ducks in a barrel, doesn't it? Seems plenty of ordinary Japanese have even been doing it with their savings.

They're banking on Japan's need to keep its currency low to make its exports competitive in world markets. So, the yen-carry trade is a bet on a political-economic priority, which doesn't exactly qualify it as a sure thing.

Actually, there are no accurate figures on the yen-carry trade. Brad Setser, my guru on global liquidity, thinks the "visible" part of it is only $300 billion. Could investors get their hands on $300 billion yen to reverse their arbitrage trade? So what if they didn't? I don't see the world falling to pieces because of one large, very risky trade.

You want to worry? In March Merrill Lynch's Jesper Koll, an economist based in Japan, wrote that "global banks may have much higher yen asset exposure than generally assumed. ... The unwinding of the yen-carry trade is not just about paying back short-yen currency positions. Surely, global funds leveraging in yen to buy Japanese stocks and real estate must be considered part of the carry trade as well." This part of the trade remains invisible to us worrywarts.

The recent weakness in the yen has caused more investors globally--including individual Japanese--to borrow yen and invest in U.S. dollars or many other currencies that have interest rates well above Japan's 0.50%.

Quite a bit of the trade is taking place in the derivatives market, which suggests that the yen-carry trade has reached another all-time high.

To hedge the wide spread between the costs of borrowing in Japan and investing abroad, Howard Simons of Bianco Research in Chicago, my choice as top U.S. expert in the yen-carry controversy, suggests buying a three-month forward option on the yen at the Chicago Mercantile Exchange for an annual cost of 108 basis points.

For the moment, this leaves a net profit of almost 300 basis points if the yen stays weak--attractive if you're doing it with borrowed funds. Today it's 122 yen to the dollar. But unhedged, you lose your 450-basis-point spread between the cost of borrowing the yen and investing in the dollar if the yen goes to 117, which is possible.