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Friday, March 02, 2007



as noted by brad delong, brad setser saw in the aftermath of the february 27 dislocation that the flight to currency quality was -- for the first time in a long time -- not into the dollar but the yen.

Fair enough. The currencies of countries with big current account deficits facing a shortfall in private inflows aren’t classically considered the gold-standard by those looking for a safety.

That though is a bit different than last spring, when the dollar did benefit for a while from the flight out of emerging markets in May (more here). I think Macro man probably has this story right: after the April 2006 G-7 communique (the one that briefly made Dr. Roach an optimist) some big players started to bet that the dollar would fall. In practice, that meant that they ended up using the dollar to finance their high-carry bets on Turkey and Brazil. Or to finance their bets on Turkish, Brazilian and Russian equities. When those bets unwound in May and June, the dollar got a bit of a boost. Today, though, it was the yen that got the big boost. Bloomberg:

The yen also advanced 4.1 percent against the Turkish lira, 3.9 percent versus the South African rand and 2.8 percent against Iceland's krona as investors shunned riskier assets in emerging markets following a rout in Chinese stock market shares.

Yet more circumstantial evidence that leveraged bets on the emerging world right now are – or were -- financed not with dollars but with yen and swiss franc.

this is the unwinding of the carry trade, which is clearly spooked by what has transpired in the last week. setser further notes the commentary of simon derrick of the bank of new york:

USD/JPY’s 2.19% fall, understandably enough, captured a great deal of the attention yesterday given that this was the pair’s 6th largest daily decline this decade, dwarfing the somewhat anaemic 0.44% rally seen in EUR/USD. However, it is on the JPY crosses that the really interesting story emerged. GBP/JPY, for example, managed to stage its largest daily decline since May 2001, losing a substantial 2.27% before making a modest (0.4%) recovery overnight. AUD/JPY and NZD/JPY were even more extreme, losing 2.89% (the largest drop since 2002) and 3.72% (the largest daily move we have a record of) respectively. ZAR/JPY collapsed by 4.46% (the largest decline since early 2004) while HUF/JPY dropped a slightly more modest 3.48%. In short then yesterday was not about the USD at all but rather about the use of the JPY as a funding currency to invest in a variety of high yielding (and, in some cases, relatively illiquid) currencies and what happens to these trades when risk appetite declines.

The question now is whether this unwinding will continue. Although we cannot speak as to whether the more general retreat from risk will continue (we suspect it will), the conditions are certainly ripe for a more sustained sell-off in JPY crosses. If we assume that a significant number of JPY funded investments were put back on in the latter part of last week in the aftermath of the BOJ policy boards decision then it seems reasonable to estimate that the overall scale of the JPY carry trade going into yesterday was at close to record levels. It therefore also seems reasonable to suppose that there are still a substantial number of positions to be unwound despite the events of the past 24 hours. With valuations still looking stretched (on a yield basis) in a number of these crosses, yield spreads narrowing smartly (particularly in GBP/JPY and NZD/JPY) and the technical picture looking increasingly negative (major trendlines either under threat or broken and declining momentum), we maintain our view that there is plenty of space for something more substantial to develop to the downside from here. It is certainly worth remembering that the unwinding (from much smaller extremes of positioning) that developed between April and May of last year saw USD/JPY collapse from JPY119 to JPY109.

it's deeply uncertain if anyone can forecast what comes next -- but derrick is obviously correct in saying that massive yen-debt-funded trades remain in place -- and that the continuing strengthening of the yen is a mortal threat to them. (notably, many asia ex-japan markets have continued to trade downward without respite as the yen strengthens against their home currencies.) the strengthening of the yen should be proeprly contextualized as well -- the zero-rate policy of the central bank went into effect in 2000, and the carry trade in higher-yielding ex-japan assets probably didn't truly begin until the volatility of the february 2000 - march 2003 period had ended. its growth was noted here in march 2005. the central bank is notorious for trying to weaken the currency in favor of exporters, but has little to do with the decline since 2005 which has seen the yen depreciate 20% -- much of that is probably short-selling of the yen to fund the carry trade despite signs of japanese economic strength. considering further the weakness of the dollar itself due to trade balance concerns, this is a considerable force in the market -- and what has transpired in the last week is only a very small move in comparison.

the carry trade may not unravel immediately, but when it does there may be a tremendous upheaval in this market.

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