CARRY TRADE

The Japanese big picture implications are profound. With interest rates at 0.50 percent,
the difference between Japan’s rates and those of other countries may continue to result
in huge outflows of capital in the form of carry trades. This is where Japanese investors
can borrow at extremely low rates and place the capital in bonds of other nations and
receive a net gain in interest rates. New Zealand and Australia have been major beneficiaries
of the carry trade. For example, New Zealand interest rates are almost the highest
in the world, at 8.0 percent. It therefore is a major attraction for the low-interest-rate
costs of borrowing yen. A popular way to do this is called the Uridashi bond. The World
Bank is a major issuer of these bonds, issuing over 2 billion yen’s worth. The total flow
of such bonds is in billions more. These bonds are of short duration, most being two to
three years. If the market perceived that Japanese rates will increase, the huge amount
of carry trade money outflow could suddenly decline. On February 27, 2007, this is exactly
what happened, with a sudden sell-off of the dollar against the yen. This caused
simultaneously a sell-off of the Dow Jones Industrial Index as big funds got out of equity
positions to cover losses in their previous selling of yen. Even gold sold off during this
crisis. Refer back to Figure 1.1, which shows the yen and the Dow on February 27. But
the sell-off didn’t last, as the interest rate differential between the Japanese rates and
other countries continued to attract carry trade investors.
The big picture on Japan is one that focuses on uncertain growth and relatively low
interest rates. Here is what the OECD Economic Outlook report stated at the end of 2006:
The current economic recovery, the longest in Japan’s post-war history, has matured
into a self-sustained expansion driven by private domestic demand. The
expansion is projected to continue, with growth of about 2% in 2007–08, thanks to
buoyant business investment underpinned by record corporate profits and private
consumption. Inflation is expected to increase only gradually (“Developments in
Individual OECD Countries and Selected Non-OECD Economies: Japan,” OECD
Economic Outlook, No 80. Preliminary edition, November 2006).
During 2007, the yen had a wide range between its index lows and highs and
ended near its lows (see Figure 7.9). Its value largely depends on what happens in
the economies and the currencies of the United States and Europe. Refer back to
Table 7.2g.
Let’s summarize several fundamental strategies that emerge from the conditions of
the Japanese economy. The first is the bet that the interest rate differences between
Japan and the rest of the world will continue. For the forex trader believing this and
looking to trade the yen, imitating the “big” money and putting on carry trades as a strategy
in a small retail account is one strategy that can be pursued.

and the trade-weighted index reverses toward the mean of 100. The fact that the trader
may observe that the yen is weakening, even in the face of good economic news, should
not be a surprise. Instead, the trader looking to buy yen would wait for the period of
technical strengthening to run its path and then look to go long the yen. Any surprise
news that is positive for the yen can just mean to be prepared for a reversal toward
strengthening. The USDJPY pair and the EURJPY pairs are the best trading instruments
for the yen.
A third strategy is to buy into the longer view that the Japanese economic recovery
will continue and that interest rate increases are inevitable. The trading strategy is to buy
the yen (sell USDJPY)—of course, at the right technical locations, which we discuss in
Part II.






By ABE COFNAS