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Currency Trading: Carry Trade Crisis Looming?

Posted April 6, 2008

‘In 1998, there was a massive yen carry trade going on. Interest rates were a half percent in Japan… The institutions were all pouring in borrowing the yen in order to buy the emerging market countries. Then we had the Asian financial crisis and a real deleveraging. At the time, the carry trade was $138 billion. Fast forward to 2007. We’re playing the same game. Major traders and institutions around the world are borrowing the yen and placing their money everywhere on all these hot assets. But couple of things are different – they’re leveraging them more and the amount of borrowing in yen is about seven times larger in 2007 than it was in 1998.’ — Jack Crooks, editor of The Money Trader

Baltimore – (TFN): The following was taken from the transcript of this week’s TFN Smart Trading Action Alert video featuring Jack Crooks. Watch this video.

Laura Cadden: Carry traders borrow low yielding currencies, like the Japanese Yen, to buy bonds denominated in higher yielding currencies, like the Australian dollar or the Icelandic krona or the U.S. dollar.

But strong exchange rate fluctuations increase the risk that over leveraged traders will have to pay back more expensive currency with less valuable currency.

With the U.S. dollar plunging and the fed slashing interest rates, what does this mean for Forex traders?

I’ve invited Jack Crooks, editor of The Money Trader to give us his take. So Jack, tell me, what is the danger in the present situation?

Jack Crooks: Well the danger is kind of what it’s already been built up in the carry trade. These carry trades have created a massive amount of liquidity in the world. Much of it has gone into other high yielding currencies. Much of it has gone into merging markets and bonds.

But much of it also has gone to this dangerous growth in derivatives and this massive leverage we have around the globe.

When you can borrow at a half percent and money looks like it’s cheap and all these asset markets look like they’re going up – stocks, bonds, commodities all at the same time – it’s kind of a lay up for these major traders.

But now we’re in a situation where we’re starting to face the great unwind and it’s very, very dangerous for the global economy.

Laura Cadden: I know some analysts have mentioned that they see strong parallels with the situation back in 1998 during the Asian currency crisis. Do you feel that’s a realistic fear?

Jack Crooks: Oh, absolutely. It’s a very good parallel and very analogous to 1998. In 1998, there was at the time a very massive yen carry trade going on. Interest rates were a half percent in Japan then.

The institutions were all pouring in borrowing the yen in order to buy the emerging market countries, the Asian tigers, Malaysia, Indonesia. They were all hot as could be.

Then we had the Asian financial crisis. The whole system broke. We had long-term capital management and we had a real payback or deleveraging at that time of the yen carry trade.

At the time the carry trade was $138 billion, which is very large. Fast forward to 2007. We have a massive carry trade again because interest rates in Japan are at a half percent.

We’re playing the same game. Major traders and institutions around the world are borrowing this yen and placing their money everywhere on all these hot assets.

But what’s different this time – a couple things different – they’re leveraging them more. They’re leveraging, they’re borrowing up five, ten, 15, 20 times and the amount of borrowing in yen is about seven times larger in 2007 than it was in 1998.

So this has created a massive, massive build-up and we’re starting to see that unwind. That’s why the yen’s starting to drive higher. It goes back to this idea of great unwind going on. This leverage is starting to unwind now in the global economy.

When traders and investors do that that have borrowed yen, they have to pay back in. When they pay back in they’re effectively buying yen and that provides that powerful lift for the yen in a world where a lot of other currencies are starting to take a hit.

Tired of reading? Watch the financial video.

Laura Cadden: So you think the yen will definitely continue to climb against the dollar?

Jack Crooks: I think longer term the yen really has scope to go much higher against the dollar because of the fact that the yen carry trade this time is seven times larger than it was last time.

However, right now I think in the near term we could see a real correction in the Japanese yen. It really looks very overdone in here and in fact, we’re playing for a correction.

Laura Cadden: “Playing for a correction?” Tell me what you mean.

Jack Crooks: Well, we’re playing for a correction in the yen. We think the sentiment and the U.S. dollar has gotten way too negative. The sentiment towards the Japanese yen has become way too positive.

One of the ways you can see that, we monitor what’s called open interest. Your viewers can do this themselves. Open interest is the amount of open contracts traded for the currency futures listed on the Chicago Mercantile Exchange in Chicago.

When we see a big amount in terms of open interest and we also see the sentiment number because open interest is broken down each week by bulls and bears, in effect; longs and shorts.

We had 76 % positive reading in the open interest on the yen. Now that’s a massive, bullish position in yen. Everybody loves the yen and we know what Mr. Market does when everybody loves the position. It usually turns around and smacks them.

So that’s why we think technically the yen looks a little over extended and from a sentiment standpoint, we think some of these bulls need to be shaken out and we could see a correction here.

Laura Cadden: So if we see profit taking, where would you suggest a trader should move those profits over in the near term?

Jack Crooks: Well, at first I think the dollar could benefit tremendously just shorting the yen against the U.S. dollar. If you’re willing to do that using currency options you would just by Japanese yen puts. Again, keep these short term because we think this correction is going to be short term.

But longer term, we think if we get through some type of commodities correction – our favorite currency are the commodity dollars, the commodity currencies because we definitely buy into the long-term story of commodities.

Again, we could see a nasty correction short term, but the commodity dollars have both high yield that the yen doesn’t have and they also have a lot of growth behind them.

So we think in particular the Australian dollar is our favorite currency and we think we’re going to see a lot of money move into that area intermediate and long-term.

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