Originally Posted by WSJ
Currency 'Carry Trade'
Becomes Harder Play
Amid Aversion to Risk
By CRAIG KARMIN and YUKARI IWATANI KANE
August 18, 2007; Page B1
As if many hedge funds and other global investors weren't having a tough enough time during the market selloff, now one of their favorite bets looks to be in jeopardy: the "carry trade."
This popular strategy -- where investors borrow money in countries with low interest rates, such as Japan, to invest in assets in countries with higher rates -- has been a source of tremendous profits for currency speculators, companies and even Japanese small investors for years.
But the onset of a U.S. credit crisis has generated an aversion to riskier, higher-yielding assets. That has caused speculators to reverse course, buying back currencies they borrowed in before they get even more expensive. The quandary now is that after many lucrative years with the carry trade, there is no obvious strategy to take its place under the current market conditions.
"That's the problem," says John Taylor, chief investment officer at FX Concepts, a New York hedge fund that specializes in currencies and manages $13 billion. "We're basically out of [the carry trade] now and it gets more complex and harder to make money."
The biggest winner during the unwinding of the carry trade is likely to be the yen, which at one point on Thursday strengthened more than 4% against the dollar -- which would have been its biggest one-day gain since 1998, had it held all those gains.
Though the yen declined on Friday, the Japanese currency surged 3.8% against the dollar for the week, and more than 9% versus the Australian dollar and 11% versus the New Zealand dollar. But these moves are generally not welcome in Japan, where a stronger currency hurts exporters and could weigh on stocks.
The rapid unwinding of the carry trade in recent days strained the $2 trillion-a-day foreign-exchange market, usually among the most liquid of any market, even during crisis periods. But on Thursday and Friday, traders complained that at certain times, trading even small yen orders became a challenge because buyers were overwhelming sellers. Some traders said the prices offered them looked so odd they suspected that some banks weren't really prepared to trade the currency at all. "They just don't want to make prices," one trader said. "They don't know where prices are."
Earlier this year, Mr. Taylor said, his firm borrowed money in yen at near-zero rates and invested that money in New Zealand dollars and Australian dollars, where those rates recently have been 6% to 8%.
Since then, the firm has been looking for another strategy as reliable. It won't be easy. Goldman Sachs said earlier this year that one basic version of the carry trade -- selling the six currencies with the lowest interest rates, buying the six with the highest, and resetting the mix once a month -- has returned 19% annually since 1998. That made it both one of the most straightforward and profitable strategies over that period.
Yet when interest rates move and market volatility accelerates, traders can get crushed as they all head to the exits trying to reverse their bets at the same time. Once the yen begins to rally, traders want to buy it back so they can close out their open loan positions before the yen gets even more expensive.
Even so, some investors are hoping that the unwinding of the carry trade is merely a short-term reaction to the credit crunch, and that it will return to fashion as it did after a violent unwinding in February and March and the spring of last year.
"I don't think that will happen now," says Rodrigo Guimaraes, a Barclays currency analyst in London. He says that three conditions are usually necessary for the carry trade to thrive: a funding currency with low interest rates, low market volatility and plenty of trading liquidity.
Mr. Guimaraes figures Japanese rates will remain low for some time. But he thinks it may be a while before volatility eases and liquidity may not return to the abundant levels seen in recent years. Meanwhile, he sees further unwinding of the trade in the days ahead. "We think that long-term investors, such as corporates and Japanese individuals, are only just beginning to unwind their long carry positions," he said in a recent report.
While the dollar strengthened a bit on Friday to 114.21 from 113.88 yen, Mr. Guimaraes sees it going to at least 110 yen.
For now, Japanese currency authorities seem unperturbed by the yen's surge, encouraging traders to maintain their bullish outlook. Japan's currency-policy point man, Naoyuki Shinohara, said he was watching the market carefully, but declined to comment on specific currency moves. Many traders took this as a sign that the ministry will not intervene to stop the yen's rise soon.
