HowardSimons040607gic June 1007

The Yen Carry Trade

Howard L. Simons

Global Interdependence CentreJune 11, 2007

Long-Term Interest Rates - 1900 to 2004

Bianco Research L.L.C.An Arbor Research & Trading Affiliated Company

Independent · Objective · Original———————————————————————————————————————————————————————————————————————

Bianco Research, L.L.C June 11, 2007 2

Intr

• Short-term (3-month LIBOR) carry trade and its components:– Interest rate spread– Spot rate changes– Total carry

• The importance of the yen carry trade to:– Emerging markets– G-10 markets

• Reading Bank of Japan policies• The Bank of Japan’s task ahead

Topics To Be Covered


Universe Examined

• A total of 29 different currencies have three-month LIBOR histories over the post-January 1999 timeframe

ISO Code Country ISO Code Country ISO Code Country

ARS Argentina GBP United Kingdom PHP PhilippinesAUD Australia HKD Hong Kong PLN PolandBRL Brazil IDR Indonesia SEK SwedenCAD Canada INR India SGD SingaporeCHF Switzerland JPY Japan THB ThailandCLP Chile KRW Korea TRY TurkeyCOP Colombia MXN Mexico TWD TaiwanCZK Czech Rep. NOK Norway USD United StatesDKK Denmark NZD New Zealand ZAR South AfricaEUR Eurozone PEN Peru


• Spread returns for each individual currency are based on borrowing at the three-month LIBOR rate of the lower-yielding currency (LY3) and lending at the three-month LIBOR rate of the higher-yielding currency (HY3)

• The net carry return is the difference between the long return (top) and the short return (bottom)

1*

2601Re

1

3 −⎥⎥⎦

⎤

⎢⎢⎣

⎡⎟⎟⎠

⎞⎜⎜⎝

⎛+=

−t

tt LYS

LYSHYturnLong t

260

Re 3tLY

turnShort t =

Constructing The Carry


• Even when presented on a semilogarithmic scale, short-term JPY rates are an outlier– CHF LIBOR has averaged 12.29 times JPY LIBOR since the January 1999 introduction of the EUR

• Two currencies, the TRY and ARS stand out on the opposite end for having unusually high short-term rates

• Several G-10 countries with high-yielding currencies (NZD, AUD and GBP) have unexpectedly low σ. The opposite is true for several Asian currencies (TWD and KRW)

– One possibility here is the G-10 central banks have adopted greater transparency and hence provide fewer surprises to the markets

Three-M onth Interest Rate Returns On Selected CurrenciesJanuary 1999 Onwards

0.000%

0.001%

0.010%

0.100%

1.000%

TRY

AR

SB

RL

IDR

MX

NC

OP

ZAR

PH

PP

LN INR

PE

NN

ZDC

LPA

UD

GB

PN

OK

KR

WTH

BC

AD

CZK

US

DD

KK

HK

DS

EK

EU

RTW

DS

GD

CH

FJP

Y

Ave

rage

Dai

ly R

etur

n (R

osea

te C

olum

ns)

0.000%

0.001%

0.010%

0.100%

1.000%

Stan

dard

Dev

iatio

n O

f Dai

ly R

etur

n (B

lue

Line

)

Average IR Return(Left Scale)

Standard Deviation IR Return(Right Scale)

Short-Term Interest Rates And Their Variance


Correlation Matrix Of IR Spread Returns

• While we might feel safe in concluding IR spreads are correlatedpositively (blue font, green cells)

• While generally true for 25 of the 29 currencies examined, it is not true for the BRL, ARS, AUD and NZD. These exhibit large swaths of negative correlation (red font, yellow cells)– All four of these currencies have had to maintain high and contra-

cyclical interest rates


• Let’s look at the total return of borrowing in the JPY and lending elsewhere– The TRY and ARS still stand out as having the highest total returns– The AUD and ZAR, two currencies with heavy commodity linkage, have exceptional σ

in their returns• Several currencies switched rank

– The PLN moved higher– The COP moved lower

Yen Carry Risk And Return

Risk And Return In T hree-M onth Carry Against JPY Since January 1999

0.01%

0.10%

TRY

AR

S

PLN ID

R

MX

N

AU

D

NZD

BR

L

CZK

KR

W

INR

PE

N

PH

P

ZAR

NO

K

CA

D

CO

P

GB

P

THB

SE

K

DK

K

EU

R

CLP

US

D

HK

D

SG

D

CH

F

TWD

Ave

rage

Dai

ly R

etur

n Vs

. JPY

(Ros

eate

Col

umns

)

0.5%

0.6%

0.7%

0.8%

0.9%

1.0%

1.1%

1.2%

1.3%

1.4%

1.5%

Stan

dard

Dev

iatio

n of

Dai

ly R

etur

ns (B

lue

Line

)

Average JPY Carry Return(Left Scale)

Standard Deviation JPY Carry Return(Right Scale)


Decomposing The Yen Carry Trade

• We can break the total return (blue line) into interest rate spread (green column) and spot rate (red column) components

• The TRY and ARS both had interest rate gains high enough to offset spot rate losses

• The BRL’s rate gains were insufficient to prevent it from sliding lower in rank

• The PLN’s spot rate component was positive, accounting for the aforementioned shift higher. The COP’s was a robber, though

Analyzing The Yen Carry T rade Since January 1999

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

TRY

AR

S

PLN ID

R

MX

N

BR

L

NZD

AU

D

CZK

KR

W

INR

PE

N

PH

P

ZAR

NO

K

CA

D

CO

P

GB

P

THB

SE

K

DK

K

EU

R

CLP

US

D

HK

D

SG

D

CH

F

TWD

Dec

ompo

sitio

n of

Ave

rage

Ann

ual R

etur

n O

nYe

n C

arry

Tra

de

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Ave

rage

Ann

ual T

otal

Ret

urn

On

Yen

Car

ry T

rade

RateSpotTotal


• If we map average annual stock market returns in USD terms against the average annual total return on the yen carry trade, we find a strong positive relationship (β=1.54) between equities and the yen carry once Turkey & Argentina are excluded

• If the total return on the yen carry trade is dependent more on interest rate spreads than on spot rate returns, we would have to conclude capital inflows outweigh the negative effects of higher interest rates

The Yen Carry Trade And Equity Markets

Positive Correlation Between Yen Carry And Equities

0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

17.5%

20.0%

22.5%

25.0%

27.5%

30.0%

0.0%

2.5%

5.0%

7.5%

10.0

%

12.5

%

15.0

%

17.5

%

20.0

%

22.5

%

25.0

%

Average Annual Return On Yen Carry Trade

Ave

rage

Ann

ual E

quity

Mar

ket R

etur

n, U

SD

Turkey

Argentina


Decomposing Equity Market Relationship

• If we exclude Turkey & Argentina from the analysis, we can see the strong positive relationship (β=1.08) between the interest rate spread component of the carry trade and equity returns (top chart)

• The relationship between the spot rate component and equity returns (bottom chart) is near-random (β= -.085)

• Restated, equity markets in high-interest rate spreads benefit directly from the capital inflows engendered by the carry trade. An increase in JPY LIBOR or a narrowing of the spread poses a threat to these markets

Positive Correlation Between Rate Component of Yen Carry And Equities

0%

3%

5%

8%

10%

13%

15%

18%

20%

23%

25%

28%

30%

0% 5% 10%

15%

20%

25%

30%

35%

40%

45%

Average Annual Return On Interest Rate Spread Component Of Yen Carry Trade

Ave

rage

Ann

ual E

quity

Mar

ket R

etur

n, U

SD

Turkey

Argentina

No Correlation Between Spot Component of Yen Carry And Equities

0%

5%

10%

15%

20%

25%

30%

-20.

0%

-17.

5%

-15.

0%

-12.

5%

-10.

0%

-7.5

%

-5.0

%

-2.5

%

0.0%

2.5%

5.0%

7.5%

Average Annual Return On Spot Rate Component Of Yen Carry Trade

Ave

rage

Ann

ual E

quity

Mar

ket R

etur

n, U

SD

Turkey

Argentina


• The Bank of Japan’s two moves to raise rates in 2006 and 2007 (green lines) had animmediate and visible impact on emerging market equities

• The BOJ moved to restore funds in its current account balance in June 2006 and assured the world no further rate increases would be coming in short order in 2007

• Is there a “BOJ put” in global markets if their moves to raise rates become disruptive? And, if so, is this really a bad thing?

Emerging Market Equity Impact

Short-T erm Yen Rates M atter

0.01%

0.10%

1.00%

Apr

-04

Jun-

04

Jul-0

4

Sep

-04

Nov

-04

Jan-

05

Mar

-05

May

-05

Jul-0

5

Sep

-05

Nov

-05

Jan-

06

Mar

-06

May

-06

Jul-0

6

Sep

-06

Oct

-06

Dec

-06

Feb-

07

Apr

-07

Thre

e-M

onth

JPY

LIB

OR

(Thi

n R

ed L

ine)

400

450

500

550

600

650

700

750

800

850

900

950

MSC

I Em

ergi

ng M

arke

ts F

ree

Inde

x (B

lue

Line

)Three-Month JPY(Left Scale)

MSCI Emerging Markets(Right Scale)


• The JPY/EUR cross-rate began to diverge after the Bank of Japan ended quantitative easing in May 2006

• While Europeans have been noisy regarding the JPY/EUR, the JPY/CNY cross is far more important to Japan’s global position

– In a mercantilist culture within a mercantilist region, the concept of competitive devaluation is accepted

– Just as in French, there is no word for laissez faire

Comparative Currency Strength After Yuan Peg Loosened

102.0%

102.5%

103.0%

103.5%

104.0%

104.5%

105.0%

105.5%

106.0%

106.5%

107.0%

107.5%

Jul-0

5A

ug-0

5S

ep-0

5S

ep-0

5O

ct-0

5N

ov-0

5N

ov-0

5D

ec-0

5Ja

n-06

Jan-

06Fe

b-06

Mar

-06

Mar

-06

Apr

-06

May

-06

Jun-

06Ju

n-06

Jul-0

6A

ug-0

6A

ug-0

6S

ep-0

6O

ct-0

6O

ct-0

6N

ov-0

6D

ec-0

6D

ec-0

6Ja

n-07

Feb-

07M

ar-0

7M

ar-0

7A

pr-0

7

Chi

nese

Yua

n, J

uly

20, 2

005

= 10

0%(T

hin

Red

Lin

e)

92%

94%

96%

98%

100%

102%

104%

106%

108%

110%

112%

Yen

and

Euro

, Jul

y 20

, 200

5 =

100%

(Thi

ck B

lue

And

Hat

ched

Gre

en L

ines

)

Yuan Index(Left Scale)

Euro Index(Right Scale)

Yen Index(Right Scale)

The Yen’s Post-Yuan Peg Divergence


• The yen carry, as measured by the forward rate ratio between JPYLIBOR and ten-year UST, reached its apex equilibrium in late 1995

– Ten-year UST rates continued their secular decline– Modest flattenings (arrows) in mid-1998 and late 2000 preceded global

equity market downturns, but had no negative impact on ten-year rates• The multi-generational low in ten-year UST (green line) occurred three

years before the carry started to decline

The Yen Carry And Long-Term Treasury Rates: Long View

Did T he Carry T rade M atter In T he Long-T erm?

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

6.00%

6.50%

7.00%

7.50%

8.00%

8.50%

9.00%

9.50%

Nov

-89

May

-90

Nov

-90

May

-91

Nov

-91

May

-92

Oct

-92

Apr

-93

Oct

-93

Apr

-94

Oct

-94

Apr

-95

Oct

-95

Apr

-96

Oct

-96

Apr

-97

Oct

-97

Apr

-98

Oct

-98

Apr

-99

Oct

-99

Apr

-00

Oct

-00

Apr

-01

Oct

-01

Apr

-02

Oct

-02

Apr

-03

Oct

-03

Apr

-04

Oct

-04

Apr

-05

Oct

-05

Apr

-06

Oct

-06

Apr

-07

U.S

. Ten

-Yea

r Not

es (T

hin

Red

Lin

e)

0.9975

1.0000

1.0025

1.0050

1.0075

1.0100

1.0125

1.0150

1.0175

1.0200

1.0225

1.0250

1.0275

JPY

3-M

o - U

SD 1

0-Yr

FR

R (T

hick

Blu

e Li

ne)

USD 10-Year Notes(Left Scale)

JPY 3-Mo - USD 10-Yr FRR(Right Scale)


• If we confine our view to the period after the CNY began to revalue, we see a complete lack of connection between the yen carry and ten-year UST yields

– Prior to May 2006, UST rates rose in a wide carry– Between May 2006 and February 2007, UST rates fell and rose parallel to

a flattening and widening yen carry– After February 2007, UST rates rose and that kept the carry positive

The Yen Carry And Long-Term Treasury Rates: Short View

Rising U.S. Note Yields Keeping Yen Carry Positive

4.000%

4.125%

4.250%

4.375%

4.500%

4.625%

4.750%

4.875%

5.000%

5.125%

5.250%

Jul-0

5

Aug

-05

Sep

-05

Oct

-05

Nov

-05

Dec

-05

Jan-

06

Feb-

06

Mar

-06

Apr

-06

May

-06

Jun-

06

Jul-0

6

Aug

-06

Sep

-06

Oct

-06

Nov

-06

Dec

-06

Jan-

07

Jan-

07

Mar

-07

Mar

-07

U.S

. Ten

-Yea

r Not

es (T

hin

Red

Lin

e)

1.02175

1.02200

1.022251.02250

1.02275

1.02300

1.023251.02350

1.02375

1.02400

1.024251.02450

1.02475

1.02500

1.025251.02550

1.02575

1.02600

JPY

3-M

o - U

SD 1

0-Yr

FR

R (T

hick

Blu

e Li

ne)

USD 10-Year Notes(Left Scale)

JPY 3-Mo - USD 10-Yr FRR(Right Scale)


Forward Yen Demand

• Yen borrowed in a carry trade have to be repaid

– The drop in the yen carry to ten-year UST after May 2006 had no significant effect on yen volatility (top chart)

– If there was a panic to unwind the yen carry trade and sell long-term UST in the process, it was invisible in the data

• Yen volatility has tracked the yen itself closely since the May 2006 withdrawal of liquidity by the Bank of Japan

Reduced Carry Leads To Reduced Demand For Yen

1.0210

1.0215

1.0220

1.0225

1.0230

1.0235

1.0240

1.0245

1.0250

1.0255

1.0260

1.0265

Jan-

99A

pr-9

9Ju

l-99

Oct

-99

Dec

-99

Mar

-00

Jun-

00S

ep-0

0D

ec-0

0M

ar-0

1Ju

n-01

Sep

-01

Dec

-01

Mar

-02

Jun-

02S

ep-0

2D

ec-0

2M

ar-0

3Ju

n-03

Sep

-03

Dec

-03

Mar

-04

Jun-

04S

ep-0

4D

ec-0

4M

ar-0

5Ju

n-05

Sep

-05

Dec

-05

Mar

-06

Jun-

06S

ep-0

6D

ec-0

6M

ar-0

7

FRR

, 3-M

o. J

PY to

10-

Yr. U

SD (T

hin

Red

Lin

e)

6%

8%

10%

12%

14%

16%

18%

20%

Thre

e-M

onth

JPY

Vol

atili

ty (T

hick

Blu

e Li

ne)

JPY 3-Mo - USD 10-Yr FRR(Left Scale)

Yen Volatility(Right Scale)

QuantitativeEasing Ended

Little Fear Of Yen Appreciation

108

110

112

114

116

118

120

122

Jul-0

5A

ug-0

5A

ug-0

5S

ep-0

5O

ct-0

5N

ov-0

5N

ov-0

5D

ec-0

5Ja

n-06

Jan-

06Fe

b-06

Mar

-06

Mar

-06

Apr

-06

May

-06

Jun-

06Ju

n-06

Jul-0

6A

ug-0

6A

ug-0

6S

ep-0

6O

ct-0

6O

ct-0

6N

ov-0

6D

ec-0

6D

ec-0

6Ja

n-07

Feb-

07M

ar-0

7M

ar-0

7A

pr-0

7

JPY

Per U

SD, I

nver

se S

cale

(Thi

n R

ed L

ine)

6.25%

6.75%

7.25%

7.75%

8.25%

8.75%

9.25%

9.75%

10.25%

10.75%

JPY-

USD

3-M

onth

Vol

atili

ty (T

hick

Blu

e Li

ne)

Yen(Left Scale)

Yen Volatility(Right Scale)


• Over a longer period of time, the volatility on three-month JPY forwards has led changes in the yen by 23 weeks on average

• As the yen carry trade was years in the making, we should expect to see a long-term rise in this volatility lead any immediate change in the yen

Forward Yen Demand: The Longer-Term View

Price Of Insuring Against JPY Appreciation

100

105

110

115

120

125

130

135

Jan-

99A

pr-9

9Ju

l-99

Oct

-99

Jan-

00A

pr-0

0Ju

l-00

Oct

-00

Jan-

01A

pr-0

1Ju

l-01

Oct

-01

Jan-

02A

pr-0

2Ju

l-02

Oct

-02

Jan-

03A

pr-0

3Ju

l-03

Oct

-03

Jan-

04A

pr-0

4Ju

l-04

Oct

-04

Dec

-04

Apr

-05

Jul-0

5S

ep-0

5D

ec-0

5M

ar-0

6Ju

n-06

Sep

-06

Dec

-06

Mar

-07

JPY

Per U

SD (T

hin

Red

Lin

e, In

vers

e Sc

ale)

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

Thre

e-M

onth

JPY

Vol

atili

ty (T

hick

Blu

e Li

ne)

JPY Per USDLed 23 W eeks

(Left Scale)

Three-Month JPY Volatility(Right Scale)

Quantitative Easing Ended


The BOJ’s Situation

• The world became addicted to cheap yen– When low rates failed to stimulate the Japanese economy, quantitative

easing (green lines) was employed• The first yen carry shock in May 2006 was far more a response to

reduced quantity of yen (red columns) than higher price (blue line)– The BOJ restored ¥10 trillion in June 2006; this ended the first shock

• The second yen carry shock was solely a price affair and ended as soon as the BOJ signaled a lack of hostile intent

Price And Quantity Of Yen

2.5

7.5

12.5

17.5

22.5

27.5

32.5

37.5

Mar

-00

Jun-

00S

ep-0

0D

ec-0

0M

ar-0

1M

ay-0

1A

ug-0

1N

ov-0

1Fe

b-02

May

-02

Aug

-02

Nov

-02

Feb-

03M

ay-0

3A

ug-0

3O

ct-0

3

Jan-

04A

pr-0

4Ju

l-04

Oct

-04

Jan-

05A

pr-0

5Ju

l-05

Oct

-05

Jan-

06M

ar-0

6Ju

n-06

Sep

-06

Dec

-06

Mar

-07

BO

J C

urre

nt A

ccou

nt B

alan

ce, ¥

Tril

lion

(Ros

eate

Col

umns

)

0.01%

0.10%

1.00%

Thre

e-M

onth

JPY

LIB

OR

(Blu

e Li

ne)

Current Account(Left Scale)

JPY LIBOR(Right Scale)


• The yen carry trade is very real• A wide range of global equity market returns have a strong positive

beta to the interest rate spread between local currencies and the JPY– Capital inflows outweigh high local interest rates– This is prima facie evidence of yen-dependence

• Surprisingly, the carry to long-term UST is unimportant in the course of U.S. interest rates

• Two different attempts by the Bank of Japan to reduce its impact have contributed to global financial shocks

– Both shocks were ended quickly by the BOJ itself, giving rise to the moral hazard of a “BOJ put” in world markets

• The ease with which both shocks ended is consistent with a negative-sum game reaction by markets to a perceived danger. It is neither the level of the yen carry nor the quantity of yen provided that areimportant, but rather a sense no one else has an incentive to panic

• The BOJ needs, therefore, to engage in a policy of “deposit insurance,”a public signal it will not engage in injurious policies. Then a restoration of normal interest rates in Japan can proceed

Conclusions

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Documents

HowardSimons040607gic June 1007