Global Economics

Yen Replacing Dollar in Carry Trades


As investors bet on the Fed tightening and Japan's economy staying weak, the yen once again is becoming the carry-trade currency of choice

By Oliver Biggadike and Theresa Barraclough

(Bloomberg) — The yen is poised to replace the dollar as the top funding currency for investments in cities from Sydney to Sao Paulo after borrowing from Japan became almost as cheap as U.S. loans for the first time in four months.

Rates on 90-day yen loans between banks have fallen the most in 13 years amid record deflation that prompted the Bank of Japan to start a $113 billion lending program last week. By easing demand for private-sector loans, the move helped shrink the gap between U.S. and Japanese London interbank offered rates by two-thirds over the past three months to 0.024 percentage point, the least since Aug. 26, data compiled by Bloomberg show.

Investors are betting Libor rates in the U.S. will be higher by June as it recovers from the recession quicker than Japan, according to Bloomberg data. The U.S. will expand 2.6 percent in 2010, twice as fast as Japan, median forecasts in Bloomberg surveys of as many as 82 economists show. That may entice traders to shift to yen from dollars to buy assets in higher-interest countries like Australia and Brazil, weakening Japan's currency and shoring up the dollar, as advocated in public statements by both governments.

"The dollar's role as a funding currency is fleeting at best," said Samarjit Shankar, a foreign-exchange group managing director in Boston at BNY Mellon, the world's largest custodial bank at more than $20 trillion in assets. "When central banks start raising rates, the yen will be left behind as the primary funding currency."

The yen fell 7.7 percent in the five months after the last time Japanese loans became cheaper, in August 1993. That plunge followed a 45 percent gain in the previous three years, when American rates were mostly lower.

Libor Spread

Japan's currency also tended to slide as the Libor spread between the two countries widened during the 13 years that U.S. loans cost more, from 1993 until Aug. 24. The yen depreciated 24 percent in five months in 1995 as that spread expanded by 41 basis points, or 0.41 percentage point. It weakened 13 percent in 2005 as Japan's borrowing costs became almost 2 percentage points cheaper than in the U.S.

This year's falling U.S. loan costs encouraged investors to sell dollars in carry trades, which seek to profit by using money from low-interest economies to buy assets in higher- yielding countries. Since American rates began dropping in March, the dollar has lost 9.4 percent against the yen, almost twice as much as the U.S. currency had weakened in the prior 10 months.

The three-month yen Libor rate fell to 0.28 percent on Dec. 11, from 1.09 percent on Oct. 8 last year, following its biggest 14-month plunge since 1996. The U.S. rate last week was 0.25 after its largest drop since 2002.

Cash and Carry

Since U.S. borrowing costs fell below Japan's in August, buying Australian dollars with U.S. funds has produced a 9.9 percent profit, Bloomberg data show. With Brazilian real, the trade gained 6.9 percent. Using yen as a funding currency would have gained less than half as much against the Aussie and barely broken even versus the real.

"The difference between U.S. dollar and Japanese interest rates in general, including Libor rates, is one of the main drivers of the dollar-yen," said Masafumi Yamamoto, Tokyo-based chief foreign-exchange strategist at Barclays Capital. Based on British Bankers' Association surveys, Libor rates are what banks charge each other for loans and serve as benchmarks for $360 trillion worth of financial products globally from home mortgages to corporate bonds.

Weaker Yen

"A higher dollar Libor rate than yen Libor rate means stronger dollar versus yen," said Yamamoto, who predicts Japan's currency will fall to 96 by June and to 100 by the end of 2010, an 11 percent drop from its Dec. 11 close, at 89.10. Median estimates from as many as 41 strategists surveyed by Bloomberg see the yen weakening to 93 by mid-year and to 97 six months later.

The dollar traded at 88.86 yen today, after falling 1.6 percent against the yen last week, down 2.5 percent for the year. The greenback bought $1.4624 per euro, after gaining 1.7 percent for the week and down 4.7 percent for the year. The U.S. Dollar Index measuring its performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona added 0.9 percent last week and is down 5.8 percent for the year.

Investors are betting that the Bank of Japan will keep its 0.1 target rate through next year and that the Federal Reserve will abandon its near-zero benchmark.

Future Chances

There's at least an 88 percent chance the U.S. will raise rates in 2010, up from 78 percent on Nov. 24, futures on the CME Group show. Prices indicate a 46 percent likelihood of an increase by June, up from 30 percent on Nov. 30. By contrast, overnight interest-rate swaps traders see no chance that the BOJ will increase its benchmark next year, Bloomberg data show.

Trading in forward contracts on three-month swaps, used to hedge against Libor fluctuations by agreeing to pay or receive a specified rate starting on a future date, show U.S. borrowing costs rising above Japan's within six months.

The yen hit a 14-year high of 84.83 per dollar on Nov. 27, less than three weeks after U.S. Treasury Secretary Timothy Geithner said a "strong dollar" is "very important." Prime Minister Yukio Hatoyama said on Dec. 2 the yen's rise can't continue, Nikkei newspaper reported.

There is "no doubt" that accelerating yen gains would hit exporter profits, said Chief Cabinet Secretary Hirofumi Hirano on Nov. 26 in Tokyo. That would be a "huge risk" for auto makers, Nissan Motor Co. Chief Operating Officer Toshiyuki Shiga said on Nov. 19 in Yokohama.

Intervention

Chances are increasing that Japanese policy makers will sell the currency to prevent damage to the economy from further gains, said Sophia Drossos, co-head of global foreign-exchange strategy for Morgan Stanley in New York.

Options traders are the least optimistic on the yen since before the bankruptcy of Lehman Brothers Holdings Inc. pushed up volatility in currency markets and forced investors to buy protection against yen gains. The cost on Dec. 4 of hedging for a month against a gain was the cheapest relative to guarding against a decline since February 2007, so-called risk reversal rates show.

Japan's struggling economy and signs of a U.S. recovery are shifting the carry-trade funding advantage back toward the yen, where it had been since 1993, when the BOJ cut rates in an unsuccessful attempt to avert a recession that sparked a decade of deflation.

Unemployment

Employers in the U.S. eliminated 11,000 jobs in November, the fewest since the recession began, and unemployment fell to 10 percent from 10.2 percent a month earlier, the Labor Department reported on Dec. 4. The dollar rose that week against the yen by the most since 1999, advancing 4.7 percent.

"The U.S. economy will perform strongly; the Fed will tighten," said Adam Boyton, a senior currency strategist in New York at Deutsche Bank AG, the world's biggest currency trader. "It makes the yen again a much more attractive vehicle for funding carry trades."

In Japan, the economy has shrunk 7.7 percent since 2008's first quarter, the steepest decline in at least 29 years. Prime Minister Hatoyama is boosting borrowing to a record 53.5 trillion yen ($607 billion) in the year ending March 2010 to support the economy and slow deflation.

Consumer prices have fallen 2.5 percent in the past year, the sharpest 12-month decline since at least 1970, sparking demand for the nation's debt and pushing down bond yields as investors bet the securities' fixed payments will gain purchasing power.

Real Yields

Mitsubishi UFJ Financial Group Inc. and Yasuda Asset Management Co. say they are buying the bonds even though Japan's 1.23 percent 10-year yield is lower than in the U.S., U.K. and Germany. That's because deflation has driven so-called real yields up to 3.78 percent, compared to the U.S.'s 3.7 percent.

From 2004 to 2007, carry trade investors who sold borrowed yen to invest in Mexican pesos, South African rand, Brazilian real and New Zealand and Australian dollars earned as much as 84 percent, Bloomberg data show.

The trades benefited from interest rates as low as zero in Japan and three-month bill yields as high as 8.4 percent in New Zealand. The popularity weakened the yen more as it fell as much as 13 percent in that period, further increasing carry profits.

Last year's financial crisis magnified price swings and caused the trades to lose money. Dollar-yen volatility surged on Oct. 24, 2008 to 42 percent as Japan's currency rallied 27 percent from 110.66 on Aug. 15, 2008 to 87.13 on Jan. 21, erasing carry trade profits from the previous four years.

'World's Weakest'

Now, narrowing interest-rate differences are making the yen the funding currency of choice again. Six-month borrowing costs in yen fell below dollar rates for one day last week after the Bank of Japan announced its 10 trillion yen ($112.7 billion) program on Dec. 1 to offer three-month loans to commercial banks at 0.1 percent interest. The central bank said on Dec. 10 that it had initiated the program with an 800 billion yen injection into the banking system.

Japan's currency "may become the world's weakest," said Keiji Matsumoto, currency strategist at Nikko Cordial Securities Inc. in Tokyo.

To contact the reporters on this story: Oliver Biggadike in New York at obiggadike@bloomberg.net; Theresa Barraclough in Tokyo at tbarraclough@bloomberg.net.


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