The carry trade could end as Japan looks to raise interest rates on the back of an strengthening economy

By: Phillipa_Green

As Japanese growth numbers for 2006 and 2007 have been revised higher to 2.5%. the Japanese central bank is increasingly looking to raise interest rates further from the current 0.25%, after spending many years at 0% (up from 0% in July 06). Interest rate forecasts suggest that rates could rise to as high as 2.5%, which could spell an end to the 'carry trade'.

What is the carry trade and why is it important ?
At its most simplest the carry trade is borrowing in Japanese yen at or near 0% interest rates and investing in assets in other currencies, including bonds, stocks, property that yield a much higher return. Since Japan has had low / even negative interest rates for a long time, this has encouraged many speculators / companies / financial institutions to take advantage of the 'carry trade', by effectively shorting the Yen. One example of the impact of the carry trade is in the 0% credit card deals, which have been thus far relatively easy to finance by the card issuers.

What would happen if Japanese interest rates rose ?
Should the carry trade no longer prove profitable due to either Japanese interest rates rising, or the assets that the borrowed funds are invested in no longer perform, then there would be a flow of funds out of those assets which would have the effect of depressing those markets further. I.e. The US Housing market would be further impacted by direct liquidation of properties that include carry trade funds and indirectly through credit becoming tighter as the banks are no longer have the advantage of borrowing in Yens at or near 0% to loan to home buyers. This would have a knock on effect as other markets suffer a similar fate, notably the US Bond & Stock Markets which are probably the biggest beneficiary of the carry trade. The reaction of these markets could be quite severe in response to the unwinding of the carry trade positions.

What are the chances of the Carry trade unwinding during 2007 ?
As stated at the beginning of this article, the key to the end of the carry trade will be the strength of the Japanese economy and the relative weakness of the US economy, for it would take a number of interest rate hikes by Japan to close the gap with the USA , UK, with a differential of some 5% !, Even against Europe there would be a long way to go. However a hard landing in the US, would imply sharp cuts in US interest rates during 2007.

Another reason to suspect an orderly unwinding of the carry trade is that interest rates tend to change in small steps of 0.25%, and usually these steps are well indicated beforehand through statements by the Central banks, therefore it would take a year or more of Japan raising rates in small increments and the US cutting rates in small increments for interest rates to reach a point where the carry trade is no longer feasible. So the market would have plenty of warning and opportunity to unwind.

Undoubtedly even a small narrowing of the spread would hurt some financial institutions such as hedge funds which are known for highly leveraging their positions, and which may be caught out. But most financial institutions such as Banks do not heavily leverage their carry trade positions.

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