Saturday, August 18, 2007

Is yen the new market villain?

The yen's appreciation to the dollar has taken most analysts and market participants by surprise. Experts were expecting the yen to touch 116 levels, but it has already appreciated above 113. This is an 8-9% appreciation in just two-three weeks. There is a global sell-off in markets with investors rushing to exit their carry trade positions and the Nikkei has seen one of its worst intra-day falls ever since 9/11. Indian markets have been falling like ninepins and are breaching one resistance level after another.

This unwinding was prompted by investors who are worried about the happenings in the US sub-prime mortgage market, extend of the damage and the impact that it could have on global liquidity. A lot of the carry trade unwinding has happened already but analysts feel that more unwinding could still be remaining.

Anil Manghnani of Modern Shares & Stock Brokers feels that after sub-prime, yen carry trade could be the next villain. "First it was sub-prime and now it seems to be yen carry trade. The way Asia has traded in the last three days, suggests there is still some unwinding left in the yen carry trade. The way a lot of delivery base selling took place in some of the larger A group blue-chip stocks would suggest that there is still some pain left in the system," he added.

So, what is this yen carry trade all about?

In the mid- and late-1990s, Japanese interest rates were almost near zero. Their economy was fighting a deflation and the central bank there progressively reduced interest rates in a bid to spur households and businesses to spend, invest, and revive the economy, which was in deep recession. Meanwhile, when Japan was in a slump the rest of the world tried to have a good time at its expense and thus was born the yen carry trade.

Investors used to borrow in the yen and convert the same into dollars to invest and take advantage of low interest rates on the Japanese currency.

The trick in making money out of the yen carry trade has always been to catch the yen in phases of depreciation, which has been few and far between.

This was a sound strategy, which was profitable in a depreciating yen scenario. Now, with the yen appreciating, tables are beginning to turn.

To aggravate matters the Bank of Japan, or BoJ, may also raise interest rates in its August 23 meeting. This could have huge fallout in India as well as a number of domestic companies had tied up loans when the yen was depreciating, which was to be settled in dollars. However, most companies have not hedged against the sharp upmove in the Japanese unit. A number of corporates that had swapped their rupee and dollar loans into yen through synthetic currency futures may now be in a soup.

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