"Mrs Watanabe" - BIS warning

Mrs Watanabe is the designation used to describe the typical Japanese housewife. Next to her usual household activity, she is also actively playing the market of foreign currency (forex). Carry trade refers to the process of borrowing low yield currency and selling it against a high yield currency. Not exactly carry trading is the fact that Mrs Watanabe is also selling her JPY outright - which hardly generates interest income on her domestic savings' account - and buys higher yielding currency such as Australian $, Kiwi $ etc.

These kind of trades at various point in time can create huge benefits for investors. Let's take a look at a strategy of shorting the JPY and buying into Brazilian Real in the period 2005-2007. If Mrs Watanabe stayed at home and played the Nikkei in her own currency, she would have pocketed 33% over a 3 year period. If she sold her JPY, bought BRL and bought a basket of Bovespa stocks, she would have pocketed 143% on her equity investment . On top of that, the Brazialian currency appreciated from 37 JPY to 62 JPY for 1 Real (68%) during the same period. Not bad for a 3 year investment period.

The JPY is not the only currency used as a "cheap" funding device. Closer to home, the Swiss Franc has been a very popular shorting instrument in Eastern Europe. In the 18 month period leading up to the start of the credit crisis in 2007, Hungarian retail customers borrowed some 3,25 bio CHF for home mortgage purposes. At the same time, the total stock of Swiss Franc loans in Hungary reached about 7,5% of Hungary's GDP. Unfortunately for a vast majority of Hungarians, this little game has cost them a lot of money and brought home-owners at the brink of disaster : The CHF has gained some 43% against the Forint since the crisis outbreak in 2007.

But the carry trade has other consequences as well. Let's have a look at correlations between the Australian/Yen relationship (white Rhs) and the S&P500 (orange Lhs) :

If we look at carry opportunities, the AUD gave some 6% extra yield over JPY early 2008, 3% early 2009 and on average 3,5% at present. The carry differential has not changed a lot over the past 12 months, yet the exchange rate moved by 33% since March 2009. And it moved in line with other asset classes, such as the stock market (cfr graph) or commodities etc. The same line of reasoning applies to Europe. Consider the correlation EUR/JPY (orange, Lhs) and the Eurostoxx50 (white, Rhs) :

In case of Eur/JPY, the opportunities to "carry" have almost entirely vanished since the ECB slashed rates from 4,25% towards 1% (JPY rate unchanged). And yet, since March 2009, the carry trade resumed until recently, regardless. Both charts prove that we are rallying a bit on automatic pilot : when equity markets resume an upward trend, the JPY is sold, whether or not under the pretext of carry trade. And when risk appetite vanishes, we have mass unwinding of positions. Look for instance during the month of May 2010 when the JPY went in no time from 125 to 110 against the euro. It seems the EUR/JPY has become a proxi for the VIX or "fear gaugue", even intra-day.

Twenty years ago, a 15 or 20% move in a particular currency was called a crash or devaluation when instigated by official policy ; today, such moves - or even bigger ones - are labelled "market correction" or "unwinding of positions". When we look at the first graph, the AUD in no time lost practically half (!!) of its value against the JPY in October 2008. In the second graph and wrt the same period, EUR/JPY moved from 170 to 110 in no time. Have we lost touch with reality ?

Since the start of the 90ies, foreign exchange has become an investment class of its own. At the peak early 2007, total forex daily turnover averaged 3,200 bio $, quadruple its level of 1992 when George Soros made his famous assault on £. Of the average volume, 40% comes from non-bank financial groups, compared to less than 20% a decade ago. It proves that next to Mrs Watanabe, large investment funds are treating forex as a major investment. And that's the current problem, also in business cycle terms. With this acceleration of investment and part "hot" money, the trades accelerate volatility : if unwinding takes place, the trade becomes too crowded and the exit too narrow. A carry which over a couple of years generated some profit can be wiped out in a matter of days, sometimes hours or split seconds. At the same time, the herd behavior has an impact on real life, meaning international trade. Exchange rates can trade far from their Purchasing Power Parity equilibrium for a long time. And when the correction moves in, the movement searches for the other extreme. It's a bit like the cob-webb theorem (spider rag) where the exchange rate is permanently in an unstable (explosive) disequilibrium, with the spider each time moving further away from the equilibrium (centre of the rag).

Correlations do not necessarily point to post hoc-propter hoc conclusions. Yet it's eye-catching and one cannot escape the feeling that carry trades are responsible for asset bubble creation. Advocates of carry trade admit that volatility is the name of the game - sometimes caused by speculation - but the final argument in favor always is and will be "carry trades add liquidity and efficiency to the markets". Lord Adair Turner - head of the UK financial regulator - has a different point of view. For him, many corners of the markets are "socially useless" and carry trades qualify for this. In addition, this kind of activity is "of zero value and potentially destabilizing", dixit Turner. In its latest year report (28/06/10), the BIS - central bank of central banks - issues an identical warning :

"Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risk, induces a search for yield and delay balance sheet adjustments. Furthermore, the resulting yield differentials encourage unsustainable capital flows to countries with high interest rates. Because these side effects create risks for long- term financial and macro-economic stability, they need to be taken into account in determining the timing and pace of normalization of policy rates"

It's exactly what we have witnessed in 2009 : with ZIRP (zero interest rate policy) around the globe, we had an asset class horse race in which all the horses - equity, commodities, corporate bonds, government bonds, gold, etc - almost simultaneously crossed the finish line, a unicum in history. And with a current abundant choice of low interest rate - cheap funding currencies, the odds on future asset bubbles increase day-by-day. The BIS is therefore right in issuing the following warning : " The big and justifiable worry is that, before it can be reversed, the dramatic easing in monetary policy will translate into growth in broader monetary and credit aggregates. That will lead to inflation that feeds inflation expectations or it may fuel yet another asset-price bubble, sowing the seeds for the next financial boom-bust cycle".