Why carry trade investors should be getting nervous

The big currencies story at the moment is the yen-based carry trade, where speculators borrow cheap yen and exchange for higher yielding currencies, which depend upon low Japanese interest rates and a weak yen. Gradually the Japanese scene is changing to such an extent that maybe the rules of the game have changed. It started in March 2006 when the Bank of Japan abandoned their zero interest rate policy. In July 2006 they raised interest rates to 0.25% and then, this week, raised them again to 0.5%. Their interest rates are still very low and extremely accommodative. Borrowing yen forms the basis of the carry trade and in itself undermines it. Those massive short yen positions will, at some time, have to be covered by buying the yen back, a process that could lead to panic as hedge funds and the like scramble to unravel their positions. We don't doubt it will happen, it's just when!

Japan is being pressed to utilise their foreign exchange reserves totaling $875 billion to support its currency. In the US, the Democrats are trying to push Bush into taking some kind of action. The weak yen gives Japan's already successful exporters a huge and possibly unfair advantage. Based upon the Big Mac' index, the yen is 30% under-valued.

With so much comment about the yen and the pressure building, proponents of the carry trade must be getting nervous. Some of the more prudent may well be looking to curtail their activity whilst they can because when the rush is on, the exits will get very crowded.

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The general view held is that there is little risk of a yen reversal but then, as we've said before in such matters, the majority is invariably wrong.