RGE - A trillion dollars gets my attention, whether it comes from the PBoC or the yen carry trade
リンク: RGE - A trillion dollars gets my attention, whether it comes from the PBoC or the yen carry trade.
Brad Setser | Feb 02, 2007Tim Lee of Pi Economics estimates that about a $1 trillion of private money is now betting that the yen will stay fairly weak.
Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets.
I certainly do not know if Lee's estimate is right. I am pretty sure that the size of the yen carry trade is far bigger than $34b (the net open positions on the Chicago Futures Exchange). I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets -- and not just the obvious ones.
Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fuelling the dash into risky assets in the past couple of years.
After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.
There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.
Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back.
In 2003 and 2004, Japan's Ministry of Finance (MoF) issued yen liabilities to finance enormous dollar purchases. Japan -- counting the BoJ's reserves along with the MoF's reserves -- now owns about $750 of dollar and euro securities (not all of Japan's roughly $900b in reserves are in securities, some are in the bank).
That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars -- and got a bit of carry in the process. And the MoF did it on a truly enormous scale.
A private investor might even want to start to take some profits ....
Of course, if the MoF started to unwind its carry trade, that might move the market. And it might trigger some of the Japanese "real" money now playing the carry trade to reconsider. The FT's Lex seemed rather confident that Japanese retail investors (Mr and Mrs Watanabe) will want dollars, kiwi and pounds so long as Japanese rates are low, no matter what happens in the foreign exchange market.
I am not so sure. I doubt most retail players remember just how far and how fast the yen/ dollar moved in 1998. I calculated the cumulative inflation differentials (CPI inflation) between the US and Japan since 1998, and, if I did the math correctly, Japanese prices today are down 3% since 1998, while US prices are up 23%. I think that means that a yen/ dollar of 121 is about equal to a yen/ dollar of 152 in 1998 in real terms. It wasn’t that weak in 98 …
Bottom line: a ton of people -- the Japanese government and Japanese "real money" as well as the leveraged community -- are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.
Then again the yen dollar and even more so the yen euro are not the only prices in the global economy that seems out of line to me ...
The yuan looks misaligned, to be sure. But also think of the Saudi Riyal. It has been pegged to the dollar forever. Which means that it has slid v. most of Europe even as oil has soared. Moreover, Saudi inflation levels – at least recorded inflation levels – have been consistently below US inflation levels. If you plot US-Saudi and US-Japanese inflation differentials on the same graph, there isn’t much of a difference.
I understand Saudi deflation in the late 90s. Oil prices tanked. The dollar soared. Deflation was the only way to generate real adjustment without abandoning the peg.
But I sure don’t understand why the riyal has – again, if the data is right – depreciated by about 10% against the dollar since 2002. That doesn’t make sense.
To be honest, I don’t fully believe that data. Service inflation is probably undercounted. Still the riyal is, like the yuan and yen, misaligned. It may not have depreciated in real terms v. the dollar, but it certainly hasn’t appreciated in real terms against the world since 2002. And oil is worth a lot more now than then.
Saudi Arabia has more oil – and makes more money – than even Exxon Mobil. Its profits (calling the increase in SAMA’s foreign assets profits, which isn’t strictly speaking accurate) were about twice those of Exxon Mobil in 2006. Exxon Mobil is worth a wee bit more now than in 2002. The Saudi riyal is not.
CommentsThere are four things that could shake the current
system
1)End of yen carry trade
2)End of yuan peg to the dollar
3)Resource shortage(especially oil)
4)Housing collapse in US
If you look at these,it is certain that except
resource shortage all other parameters can dilegently
postponed in short term.
yuan peg can be continued as long as chinese
industrialisation is complete and in short term can
be over-extended due to productivity increases in
manufacturing without causing inflation.
Yen carry trade will continue as long as yuan peg
is alive or a real inflation scare because exports
to china forms a engine of growth to them.They don't
want to distort that.
Housing bubble will not deflate fast as long as US fed
pumps liquidity into the system.
Only a resource scarcity or scare(higher commodity price)
can send shock waves.Since data on chief commodity oil
is not that transparent,we will get a rude surprise
shock that could really reorder thingsWritten by SATISH on 2007-02-02 10:10:42Here's a brief, non-technical explanation of carry trades from the Federal Reserve Bank of San Francisco if you're interested.
I find it kind of funny--and also kind of sad--that US automakers are again complaining about how the yen is artificially weak. True, it is--but it's not mainly of the BoJ's making this time around despite near-ZIRP. Blame the currency speculators. Bring on the Tobin tax, I say. This foolishness has got to stop.Written by Emmanuel on 2007-02-02 10:25:52Probably the best indication of how much money is in the yen carry trade can be found in the amounts outstanding in yen FX forward swaps.
A forward swap is an agreement to exchange a pair of currencies today at the spot rate and reverse the transaction on a pre-agreed date at a pre-agreed FX rate. If you do the math, the difference in FX always works out to the difference in interest rates between the two currencies. This is a carry trade right there, all by itself. You can keep on rolling overnight positions (tom/next, really) or longer periods and keep pocketing the difference for as long as the conditions are favorable. Such trades are by far the favorites of professionals, because they are very liquid and transparent.
According to the Bank for International Settlements (BIS), as of end June 2006 there were $3.1 trillion worth in such yen FX forward swaps (and outright forwards) at banks and other financial institutions. This should give us a pretty good idea about the carry trade. Not all $3.1 trillion, but $1 trillion is a certainty and perhaps $2 trillion. The other figure, $34 billion is way way way too small.
Written by Hellasious on 2007-02-02 11:13:03Brad,
One must respect the size of Japanese private savings, and the fact that after massive liquidity creation via QE, ZIRP and more recently nearZIRP(c), and the persistent fiscal gaps, that the people would begin to feel the cumulative effects of debasement, rising real estate prices, and ZERO INTEREST ON THEIR POSTAL SAVINGS. Like in the US, core measures of inflation are diverging from experienced inflation, and the average Japanese saver cannot fathom the risks inherent to an Investment Trust investing in "foreign" (USD) securities with a headline yield ostensibly of @5%. Like many things such as rice or automobiles, they'd much prefer securities that were Japanese, and denominated in YEN, but there is only so much abuse a passbook-saver can tolerate, so LEX has a point until we see rate normalization.
Emmanuel
Funny that in comparison to Detroit, German manufacturers rarely whinge about the exchange rate. Not that they don't feel it, or complain in their way, it's just that they ALSO typically respond by beavering away (with their supply chain engineers) on ways to cut costs, reduce material usage, improve efficiency and productivity, without firing workers or materially impactiung quality quality. Rent-seeking via lobbying is like the helicopter mom attempting to expunge any and all germs, trials and tribulations from Juniors existence. Whereas the reality is closer to that old saw: "what doesn't kill [should] you make you stronger..."
That said, the health of the markets are dependent upon periodically spanking the specs, or at least putting them into "time-out".Written by Cassandra on 2007-02-02 11:20:15http://economist.com/markets/indicators/displaystory.cfm?story_id=8649005 - "The most telling numbers are those for the Japanese yen"Written by Guest on 2007-02-02 11:35:26Finally, Americans like me can visit Japan. For 20+ years it has been too darn expensive.Written by Richard on 2007-02-02 12:11:00All the reasonings sound good except the part on inflation differentials. Based on the old exchange rate Japanese prices were exceedingly high -- food, real estate -- in the eyes of foreigners. Coupling that with some openning up of the economy is part of the driver for deflation. Not sure you can argue for stronger Yen based on PPP alone.Written by HZ on 2007-02-02 12:22:53It is even better if you are British.....I fly out on Tuesday!Written by RebelEconomist on 2007-02-02 12:23:43Cassandra--I'm also inclined to believe that German automakers are better hedged against FX fluctuations by taking out buy EUR/sell USD forwards and the like. Clearly, there is a trade element to their hedging and it shouldn't be discouraged. On the other hand, speculators don't do anything much from my POV other than to distort the yen's value even further. Pile this distortion on top of China's activities and what we end up with are region-wide beggar-thy-neighbor policies.
So much for leaving FX to "market forces".Written by Emmanuel on 2007-02-02 12:44:39Great post Brad. Thanks.Written by stuart mills on 2007-02-02 13:01:58"Strong performances by offshore-based auto makers propelled Canadian vehicle sales to their best January since 2003... Canadian sales jumped 6 per cent in January to 91,398 from 86,373 a year earlier, sparked by gains of more than 30 per cent at Nissan Canada Inc. and Volkswagen Canada Inc. and record January results racked up by BMW Canada Inc., Mazda Canada Inc., Mercedes Benz Canada Inc., and Toyota Canada Inc. "That's quite a good number," said Ted Carmichael, chief economist for J.P. Morgan Securities Canada..." http://www.globeinvestor.com/servlet/story/GAM.20070202.RCARSALES02/GIStory/Written by Guest on 2007-02-02 13:06:35
US Investment Banks profit from Carry Trade at Asian Saver expense
http://asiasentinel.com/index.php?option=com_content&task=view&id=354&Itemid=32
" It is no wonder that so many of the so-called economists employed by investment banks and hedge funds keep up constant pressure on central banks, especially Asian ones, to keep rates low. Without that there would be no fuel for the carry trade, which has enriched so many ill-deserving bulge-bracket gamblers and could potentially result in the near-collapse of the global financial system.
There is no doubt that huge of amounts of money have been made from the carry trade by investment banks, thus far mainly at the (indirect) expense of Japanese savers. But the tempo has picked up as investment bank balance sheets have ballooned and additional Asian currencies have entered the carry-trade play. But the bigger the bets, the bigger the danger, particularly when the practice seems to fly in the face of economic fundamentals and traditional assessments of what makes a strong currency.
At some point of course it will hit home that countries with excess consumption and feeble savings are weak, not strong. But for now the bankers and fund managers can play their high risk games. Once upon a time, when these players were as yet unborn, bankers learned in the nursery that currency mismatches were one of the more dangerous games in town. "Written by Dave Chiang on 2007-02-02 13:19:06thoughts for the trillionaire carry trade - hi, carry traders.
1. you are getting very big. is there no law of market speculation concerning the ratio of trades / speculative trades ? something like a law of parasitism - that the total weight of fleas cannot hope to exceed the weight of the dog ?
2. the rising tide lifts all boats. yes, but the outgoing tsunami suction only means that the tide is about to go the other way, really fast, and leave a lot of dead bodies on the beach.Written by gillies on 2007-02-02 13:40:12
To Brad Setser,
You write, ``In what rational world does it make sense for the currency of a high-investment, fast-growing, still-quite-poor country to be the funding currency for a carry trade?''.
Yet today's globalization process has always been the result of US state action in both the financial and military spheres. US Dollar Hegemony is in Wall Street's financial interest because it keeps US inflation low through low-cost imports from China and enriches US financial institutions from the carry trade. This arrangement, which former Federal Reserve Board chairman Alan Greenspan proudly calls "US financial hegemony" in congressional testimony, has kept the US economy booming in the face of recurrent financial crises in the rest of the world.
The US capital-account surplus finances the US trade deficit. Moreover, any asset, regardless of location, that is denominated in dollars is a US asset in essence. When oil is denominated in dollars through US military power projection and the dollar is a fiat currency, the US essentially owns the world's oil for free. And the more the US prints greenbacks, the higher the price of US assets will rise. Thus the US Dollar hegemony policy by the Federal Reserve and Treasury Dept gives the US a double win.
Regards,Written by Dave Chiang on 2007-02-02 14:32:51gillies,
Life would be dull without your poetic metaphors.
Must be something in the Guinness that gives the Irish their natural lyricism :)Written by FTX on 2007-02-02 14:45:48$1 trillion sounds large, but in the context of world financial maarkets strikes me as inconsequential in terms of the feared impact. I believe the market cap of global equities is 60 trillion, with double the volatility of the jpy. In other words, a move in usdjpy to 50 from 121 would cause the same pain as an insignificant loss of wealth equivalent to a 1% down day in global equities. I doubt that a jpy unwind would "wreak havoc". Also, I know of no actual hedge funds these days that borrow in jpy to buy equity tranches or other risky assets. This seems to be more a fiction of the financial press than an actual market practice. In my opinion the story that this is driven by private savers in Japan seeking yield is much more credible than it being driven by leveraged investors.Written by pb on 2007-02-02 16:10:16pb -- wouldn't an unwinding of the yen carry trade, even as unwinding of the retail yen carry trade, be associated with a host of other moves (including a widening of US interest rates and the spread on risk assets over US treasuries) that likely would be correlated with a rise in equity market volatility/ perhaps large swings in equity market valuation?
Tett, incidnetally, claimed that some i-banks were financing their holdings of the risky tranches of CDOs with yen, not that hedge funds were doing it. And she writes frequently (and i think well) about the CDO market, so I rather suspect she knows what she is talking about. Though she may be overgeneralizing from one anecdote.Written by bsetser on 2007-02-02 16:23:25I would like to commend those astute commentators who pointed out the direct relevance and central role of the forward currency swaps market in facilitating carry trades. It is arguably the easiest and most preferred method to put on a 'carry trade' by the leveraged community. It was described several years ago in a book written for a Japanese audience by a former Moore Capital trader, Ken Shibusawa, who currently runs his own hedge fund advisory firm in Tokyo (Japanese website for his company: http://www.shibusawa-co.jp/index.html).
According to him, essentially the press has got it all wrong. Yes, the underlying economics of a typical carry trade is to 'borrow' in low-yielding currency (e.g. the yen) and then 'lend' on in higher-yielding currency (e.g. the dollar), but when we discuss the actual mechanics of it, hedge funds and other highly leveraged players typically would not engage in any actual borrowing or lending. To the extent a hedge fund would consider putting on such a trade at all, it would most likely do it in the following way, or some variation thereof (we use US$/JPY levels as in Ken Shibusawa's example in the Japanese book):
Step 1. Buy US$ / Sell JPY in the spot market (say, at 120)
Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120)
Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50)
Step 4. Buy UST in the spot market
Step 5. Borrow US$ against UST in the repo market
Some comments are in order.
1. A typical currency forward swap is step 2 + step 3. However, if that's all you do, you will be expected to deliver your US$ for settlement on T+2. But remember, we are looking at a hedge fund, who does not have the money to deliver and who wants leveraged carry. Thus, he needs to create this exposure with as little initial cash outlay as possible. The best way to do that would be to take an outright forward position in the market.
2. An astute observer will have noticed that the cumulative effect of steps 1 through 3 is precisely to create such an outright forward position, whereby our hypothetical hedge fund is now short the yen and long the dollar at 118.50 on a 3-month horizon (in other words, the hedge fund promised to pay 118.50 in 3 months time for an asset which is currently trading at 120 - and the lower the US$/JPY volatility, the higher the chance that the forward contract will have converged at or around the original spot price of 120).
3. But if a hedge fund wants an outright forward position, why go through the hassle of steps 1-3? Well, it all has to do with costs and liquidity. Apparently, it is cheaper and easier to put on such a position in the currency swap market rather than as an outright forward - as the market supporting corporate and 'real money' hedging activity, it is the most liquid.
4. Notice how the trade is structured in two separate legs. There is the FX market leg, where the hedge fund puts on a position to earn the carry from the interest rate differential in the two short-term markets. Then there is the UST leg, which is a completely separate transaction: longer duration US Treasuries are purchased to earn a higher yield, but they are financed in the repo market (of course, this example assumes a 'normal' upward sloping yield curve in the US). So if (and it IS a huge if) all goes as planned in the US$/JPY and UST markets, the total carry earned on the trade is the sum of FX market carry (i.e. short term interest rate differential) and UST market carry. Another way of putting it: the hedge fund earned money from two major risk sources: currency mismatch risk and duration mismatch risk.
5. In his book, Ken Shibusawa makes an interesting observation: many press commentators focus on what they can trace in the spot markets (i.e. step 1 and step 4), and often do not pick up on simultaneous transactions in derivative markets (i.e. combination of step 2 & 3, step 5). Thus, the tendency is to interpret this as hedge funds borrowing yen and selling yen spot, thus procuring dollars and then investing these dollars in long maturity UST). While the underlying economic logic and principle is the same, the mechanics are totally different.
6. Ken Shibusawa quips in the book that while much press attention at the time was focused on global macro hedge funds, it was probably relative value shops that were particularly keen on putting on massive yen carry trades in 1997-98, following the relative success of their "Japan risk premium" carry trades in the previous years.
One final comment from me: as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...Written by Rozanov on 2007-02-02 17:51:22Rozanov -- great comment. would you mind if i elevated it to a post, with attribution?
four observations.
a) no doubt I am dense, but i still don't quite see the point of doing one and two (buying and then selling JPY); i gather it has to be necessary to set up the swap, but i still don't quite see the intuition. I get the intuition of buying $ forward at a discount, since, well, the interest rate differential implies a $ depreciation over time, even if in practice long carry strategies work b/c the depreciation hasn't exactly happened.
b) I presume that right now no one makes the duration play, since it it is a negative carry position, given the shape of the curve ... right now, all the action is on the fx side.
c) your observation about relative value funds is interesting. LTCM was one, after all. And from reading Drobny's book (inside the house of money) one thing that struck me was how many of the Hedge fund superstars of 2000 on made a killing on the eurozone convergence play. And having bet that spreads and volatility would fall inside Europe, they moved on to making similar bets in other markets ... at least that was the sense i got. Anyone who bet against convergence lost big and is no longer managing money. the same thing is presumably true for anyone who bet that credit spreads would blow out recently. they aren't managing money anymore.
d) I think you are on to something when you note "as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades." The financial ecosystem is evolving ... and right now, it is evolving toward cross currency carry plays in a big way. tis hard to make money otherwise with a flat or downward sloping yield curve and low credit spreads.
My favorite indicator of growing interest in carry trades? The rise in Brazil's reserves in January. They are up from $85.84 to $91.55 -- an increase of $5.5b. For a country of Brazil's size, that is huge. Tis about a 10% of GDP annual pace of reserve growth, maybe a bit less.Written by bsetser on 2007-02-02 22:57:49Yen is vulnerable to a correction in the short term as it couldn't break through the 122 level and as you rightly pointed out, too many people are short yen. However, the long term big picture remains bullish for Dollar Yen unless the 113 level is broken. Otherwise 135 is the upside target within the next 3-4 years.Written by PC on 2007-02-03 00:59:02A little more on the FX forward swaps as instruments for carry trades, further to Rozanov's comment and my previous further up.
A hedge fund (or anyone else) can do a forward swap in one package with his bank. The bank's dealing room will put the trade on for him and just charge him a spread on the "carry", i.e. instead of making 5% "carry", the speculator will net 4.50%. No need to go through all the individual steps outlined above. The speculator puts up margin money, typically 5% of the sums involved and sometimes as little as 2%. So to put on a $100 million swap all you need is $2-5 million in cash or acceptable collateral. If it works out as planned, the speculator's annualized gain is $4.50 million, or a return on equity of 90%-225%.
Naturally, under such high leverage conditions the potential losses are very large too.
I urge everyone to visit the BIS site and look up the relevant FX forward data for yen. The amounts have jumped very substantially from $2.3 trillion to $3.8 in 5 years. A big part of the increase has come in just 6 mos., going from $3.1 to $3.8 trillion between Dec. 2005 and June 2006 (latest available data).
For a country like Japan with near zero economic growth and interest rates, such a huge jump in swaps points clearly to speculative activity rather than commercial transactions.Written by Hellasious on 2007-02-03 01:35:53
Doug Noland is pure genius. Read this week's Credit Bubble Bulletin if you want to understand why the stock market has rallied for the last six months. Here is a portion of the article. For the full deal (free of charge) go to:
http://www.prudentbear.com/articles/show/340
Read it and be truly enlightened...
"Last year certainly provided a clear example of how the economy and financial sector are evolving, adapting and mutating systems. As analysts, we must be willing ourselves to adjust and adapt. While the housing “ATM” was absolutely crucial for consuming our way through 2001-‘03’s tepid jobs and earnings backdrop, it became much less so during 2006 (with heightened Income and equities inflation). Importantly, when it comes to employment and Income growth, I would argue forcefully that corporate Credit and liquidity conditions hold sway. Some expected the bursting housing Bubble to have a tech-like immediate and spectacular economic impact. But it actually proved more a case of Ultra-Loose Financial Conditions boosting Income growth, in the process working to stabilize inflated home prices. Relatively stable home prices, then, proved sufficient to sustain the Mortgage Finance Bubble and Credit Bubble generally.
As we now look ahead to 2007, there are notable crosscurrents, uncertainties and ambiguities. Labor markets are tight generally, with increasing pockets of exceptional tightness. There remains an inflationary bias in compensation, exacerbated by ongoing easy Financial Conditions. Corporate cash flows remain strong, fueled by unrelenting system Credit growth. Additionally, funds to borrow stay too cheap and too readily available. And the booming stock market only heightens the sense of urgency for businesses to pay up for required skills and manpower. On the one hand, if one were to extrapolate the current labor and liquidity backdrop, a strong case could be made for an even stronger year of Income growth. Yet one must these days be unusually cautious when it comes to extrapolating recent Financial Conditions.
To be sure, there is a fundamental flaw in the goldilocks analysis: It ignores the enormous ongoing degree of Credit, liquidity, and speculative excess necessary to sustain this most expansive boom. A tremendous amount of system Credit growth was required last year to maintain elevated home prices; to inflate stock prices; and to drive robust Income growth – not to mention the $Trillion or so that gushed out and further distorted global economies, markets and financial systems. Especially after last year’s Income, equities, and global inflations, even greater excess will be necessary to sustain the Credit and Economic Bubbles this year and next.
The markets are content to make and live with two bold assumptions: One, the environment is non-inflationary and will remain so. Two, there is little risk associated with the creation and distribution of this ongoing massive liquidity. Neither holds water. There is in fact considerable risk going forward that Income growth surprises on the upside, forcing the Fed to de-pause and perhaps even tighten Financial Conditions. I will suggest, however, that the greater risk lies with speculative dynamics and the inevitable reversal of speculative flows out of this nebulous Bubble I’ll label “Credit arbitrage” (multifarious activities that are essentially writing flood insurance during a drought).
I’ll conclude by theorizing that a good percentage of the seven million “services” jobs added over the past five years owe much of their existence to rampant Credit and asset inflation. They’re (seductively and dangerously) Bubble Manifestations similar to the tech employment boom that proved so susceptible and disruptive. And, clearly, accelerating Income Growth is at this point very much a Credit Bubble phenomenon. For now, these dynamics ensure extraordinary uncertainty. Yet we should expect the eventual bursting of this Bubble to initiate job and Income losses that will make post-tech Bubble dislocations look inconsequential by comparison."Written by Guest on 2007-02-03 06:55:10"Calling more regulation a "knee-jerk reaction" to the proliferation of hedge funds that "may do more harm than good," Andrew Rozanov of State Street Global Advisors has a better idea to keep an eye the ever-growing and more complex industry: Let central banks use some of their "enormous" foreign-exchange reserves and invest them in hedge funds. "Investing a portion of reserves in a broadly diversified portfolio of hedge funds," Rozanov... writes in The Wall Street Journal, "could also improve the ability of monetary authorities to monitor, pre-empt and deal with future systemic crisis." Rozanov adds such investments would allow central banks "to extract better information and more timely market intelligence," and allow them to be "proactive, rather than reactive," should another crisis such as that brought on by Long Term Capital Management in 1998..." http://www.canadianhedgewatch.com/content/news/general/?id=1251Written by Guest on 2007-02-03 07:13:27"...the issue of legal authority poses a dilemma, as Stanley Fischer, governor of Israel's central bank, noted. For while banks such as the US Federal Reserve managed to quell the crisis at Long Term Capital Management in 1998, markets are now so international in scale that they cannot easily be controlled by any single authority. That made it hard to gather data in the short term but it also made unclear who had res-ponsibility for the system in a crisis, Mr Fischer said..."
http://www.ft.com/cms/s/eae38d36-b198-11db-b901-0000779e2340.htmlWritten by Guest on 2007-02-03 07:21:18Noland writes like a crackpotWritten by Guest on 2007-02-03 07:38:31There is another reason for an astute fund to explode (no pun intended) such trade into its component parts: confidentiality. A large [and levereaged] fund must prudently use multiple prime brokers, multiple counterparties, ocassionally move positions between counterparties, to avoid anyone knowing one's precise position with high certainty and thus potentially becoming prey. LTCMs Hillenbrand would attest to the essential nature of this, and the increase (fatal in his case) in risk when ignored. While it is true that, for example, Amaranth was probably too leveraged, and too cocentrated in their energy trades, their biggest sin was likely that they violated prudence with respect to concentratiing their positions amongst individual leverage providers at a time when the market, too, knew, from prior purchases, where (Natty) and which way (long) their energy positions were geared. As a result it is likely that they were the victims of predation by astute comeptitors, feedback traders in the market, and importantly, their own leverage providers, who, for hedge and profit, literally shorted them down-river...Written by Cassandra on 2007-02-03 07:58:19Hellasious -- could you help guide me to the BIS data on forward yen data? I know the BIS banking data reasonably well, but not the derivatives data -- a link or a table number (central bank deposits for example are table 5c i think or maybe 5b of the international banking data). Want to make sure I am looking at the right data set. OTC yen doesn't seem right.Written by bsetser on 2007-02-03 08:20:01Great Discussion and Links:
From the Fed Article:
"What is puzzling from a theoretical
standpoint, however, is that investors should
even engage in carry trades, because the textbook
theory of interest parity conditions implies that
these strategies should yield no predictable profits.
As this Economic Letter has explained, the key
to the puzzle is yet another puzzle—the forward
premium puzzle—wherein currencies with high
or rising interest rates tend to appreciate, and currencies
with low or declining interest rates tend
to depreciate, as investors are lured into buying
currencies with positive interest rate differentials
and selling short currencies with negative interest
rate differentials.The evidence on the quantitative
importance of carry trades is fairly limited,
but to date it suggests that these strategies may
well have been an important factor in recent exchange
rate swings."
The carry trade speculation is significant enough to sustain the relative value of FX currencies at a "predictable", non-equilibrium level. IMO, the more likely explanation is that the Japanese print enough money to prevent the dollar from depreciating. Same with all the mercantilists. Pay no attention to the man behind the curtain.Written by Guest on 2007-02-03 08:40:33Dear Brad,
The relevant BIS yen forwards data is to be found at
http://www.bis.org/statistics/derdetailed.htm
look at the very first PDF titled
"Notional amounts outstanding, by instrument, counterparty and currency"
the CSV file right next to it will give you a historical series.
Regards
Written by Hellasious on 2007-02-03 10:03:57It is also very interesting to compare the rise of yen forward amounts from BIS with yen broadly defined liquidity (i.e. the broadest available measure of yen money supply) as reported by BOJ, between June 2001 and June 2006.
As I noted above, Yen forwards increased from $2.3 trillion to $3.8 trillion, or 65% - in dollar terms.
From BOJ, yen money supply went from Y13.07 to 14.32E14 (tough to keep track of all those zeroes in yen), an increase of just 9.6% - in yen terms.
Applying the appropriate dollar/yen exchange rates these are roughly $9.83 and $12.9 trillion, or an increase in yen money supply of 31% - in dollar terms.
So, comparing apples to apples, yen forwards rose 65% while broad money supply rose 31%. There is lots and lots of speculation going on...
Written by Hellasious on 2007-02-03 10:49:32Brad -- thanks. You are most welcome to reference my comments in your blog postings if you like.
On the 'component steps' of a carry trade, Hellasious is absolutely correct to point out that, in this day and age, a typical hedge fund would most likely have an investment bank arrange and set up such a position for them as a 'package' for a fee (which, I suspect, will be even more competitive if more prime brokerage business comes their way from the hedge fund). However, in terms of the underlying steps, I would be surprised if they are materially different from those described in my earlier posting. It will be the bank and not the hedge fund going through the motions, but essentially the process should be the same or very similar in nature.
Let me try and answer your question about why go through steps 1 and 2 by considering the other options.
1. If you do only step 1, you are going long USD and short JPY in the spot market. There are two problems with this approach as far as leveraged carry trades go. First, it's not leveraged - you will need to come up with the entire notional amount of JPY to settle this trade in two working days (T+2), so you're not really 'borrowing' anything. Secondly, you're not really trading for carry. Instead, you're putting on a directional bet: you buy US$ at 120 and hope it appreciates (or JPY depreciates), but you're not picking up any interest rate differentals. Incidentally, this type of trade typically favours high volatility environment - remember, volatility cuts both ways, so if you want to make money from a large swing up in the dollar (or swing down in the yen), you would be implicitly betting on high, not low vol. Carry trades, on the other hand, are typically low vol trades: any additional depreciation of the yen would be icing on the cake, but your main bet is that the world stays stable and predictable while you earn your carry on a leveraged basis (i.e., interest rate differential multiplied by leverage).
2. What about taking only steps 2 and 3 - i.e., the foreign exchange swap? The good news is this gives you carry: you buy 120 yen for every dollar now (on T+2) and at the same time contract to sell the newly acquired yen in 3 months' time, such that 118.50 buys you a dollar - in other words, you sold the dollar now at 120 and bought it back in 3 months at 118.50, earning the carry in the process. But the bad news is that, just like in the first comment above, you do not get any leverage, since you will need to provide an initial cash outlay on T+2 to settle the leg in step 2.
3. Why not forget steps 1 and 2 altogether, and just go for step 3? This is entirely legitimate and certainly doable. In the FX market, such a transaction is called an 'outright forward'. You agree with your counterparty bank to go long USD and short JPY based on today's spot price, but with settlement in 3 months' time - you will negotiate and agree the spot price, and then the bank will adjust it by the interest rate difference. No cash flows occur on T+2, you have effectively secured a leveraged position, and you've bought US$ at 118.50 in 3 months. Voila! The only reason you would consider doing something a bit more convoluted (like going through steps 1 to 3 above) is if it helps you save costs and earn even more money. And in competitive markets like FX you get the best prices and execution where the liquidity is the deepest. And the liquidity of spot and FX swap markets has always been (and I believe still is) much better and deeper than in the outright forward markets. Just have a look at Table B1 on page 5 of the BIS Triennial Central Bank Survey at the following link (last survey done in 2004):
http://www.bis.org/publ/rpfx05t.pdf
You are right about the inverted curve, but remember that in steps 4 and 5 in my earlier posting we are using UST and the repo market only as an example. Substitute UST for a market with a higher expected return (e.g. a steeper curve, higher credit spreads, etc.) and repo for a total rate of return swap, and you can mix and match as you like across markets, instruments and regions.
Finally, in my Bloomberg example, I suggested plotting returns to a carry basket (short 50% JPY and 50% CHF vs. long 50% EUR and long 50% GBP). For those with access to Bloomberg terminals, the function is FXCT, which you can find on the generic FXIP screen. For those without access to it, I provide below the statistics I referred to earlier:
Period: 2 Jan 2006 - 2 Feb 2007
Average annual excess return: 13.08%
Annualized standard deviation: 3.70%
Sharpe ratio: 3.54
In fund management world, any Sharpe ratio above 1 is considered very impressive, and 2 is superhuman... 3.5 will certainly get people's attention. A note of caution, however: as experienced observers of hedge funds and alternative investments will tell you, volatility and Sharpe ratios do not necessarily tell the whole story - you may be exposing yourself to risks which you are not taking into account - i.e. the higher statistical moments of return distribution, like skewness and kurtosis. But that is a whole different topic in its own right...
Written by Rozanov on 2007-02-03 10:52:22Really interesting work that you do Andrew. I'm having problems with the pdf link to the following paper but, as you may know, it's another topic that is frequently discussed on this blog:
http://72.14.205.104/search?q=cache:2BS3_WVC0XYJ:www.ssga.com/library/esps/Who_Holds_Wealth_of_Nations_Andrew_Rozanov_8.15.05REVCCRI1145995576.pdf+%22who+holds+the+wealth+of+nations%22+rozanov&hl=en&ct=clnk&cd=1Written by Guest on 2007-02-03 12:24:47Dear Rozanov,
Yes, absolutely the bank would have to go through the swap steps itself to offer the package to a customer (hedge fund, etc) and that is what actually happens all the time. You are also correct about swaps vs. outright forwards: the former is an extremely deep and liquid interbank market, while the latter is very rare in trading between banks. It is really a customer instrument.
RegardsWritten by Hellasious on 2007-02-03 12:38:44Rozanov -- thanks. watch the blog tomorrow ...Written by bsetser on 2007-02-03 12:58:33Guest, thank you -- if you send me an e-mail, I'll be happy to forward you a few of my previous articles on sovereign wealth funds.
Hellasious, thanks for your comments and clarifications. I'd be interested to establish direct contact for future reference. If you don't mind, please send me a direct e-mail as well.
Regards,
Andrew RozanovWritten by Andrew Rozanov on 2007-02-03 14:58:39Sorry Andrew, but I don’t really get this. As written, steps 1 and 2 simply cancel out, so it does not avoid using a forward. If you want to use an fx swap, presumably you need to put up cash from somewhere? Maybe there should be one spot fx transaction at the beginning, plus a swap, and another spot fx transaction when the swap matures? The first two steps are equivalent to a forward, and the last step is needed to close out the position.
I think Brad is right about a short yen forward picking up the carry as long as the yen does not move to its forward exchange rate, but that only allows you to pick up the spread between money market interest rates (assuming that they set the forward points). If you want exposure to racier $ interest rates, then you need to overlay that. In the case mentioned, the short-term funding of the purchase of a relatively long term treasury does the job, but using spread product would make it racier still.
Hedge funds did this type of trade in the late 1990s, because both sides carried positively, while there was a perceived correlation hedge in that Japan’s intervention against the yen could only continue if the US economy remained robust.
The amount of leverage depends on how much you need to put up for haircuts/margin. LTCM got away with very little, because prime brokers were competing for their business, and nothing ever seemed to go wrong. Sounds familiar!Written by RebelEconomist on 2007-02-03 15:25:11RebelEconomist -
You are right - the whole point is that steps 1 and 2 cancel each other out, leaving a synthetically created, relatively cheaper 'outright forward' position. Think about it this way: if you're a hedge fund, you can call your bank and ask them to quote you prices on:
a. spot USD/JPY
b. FX swap USD/JPY (i.e., spot + forward)
c. outright FX forward
To earn carry, you can do either b or c. Typically liquidity in b is much better than liquidity for c, so you'll get better quotes from your bank on b. The reason b is more liquid than c is probably because b is the preferred market for various 'normal' hedging activities - by corporate treasury departments, 'real money' investors, etc. In their case, they have the underlying cash outlays to put up in the first leg of the swap and to hedge in the second. Contrary to that, a carry trading hedge fund wants to put up position cheaply and with very little (and ideally absolutely no) cash outlays. So they trade in the spot market and FX swap market, with the spot trade canceling out the first leg of the swap, and only 3-month forward remains.
On closing, you are right - the steps I described in my earlier post are the ones you would take to establish a carry position. By the time your value date approaches, you either do a spot trade to close out the position or do yet another FX swap transaction to roll the position for the next 3 months.
You are right again that you can make your carry on the asset side even racier still - see my earlier post on mixing and matching through total rate of return swaps.
AndrewWritten by Andrew Rozanov on 2007-02-03 16:02:05i think $1 trln is a slightly ridiculous number, even if you include the sheer Japanese foreign asset holdings that don't really constitute carry trades per se, just a hunt for higher yields. also, the BIS derivatives data gives some clues on potential size of carry trades. but i believe they also are all notional numbers, like the US OCC data, which means they're always growing at a fairly rapid pace -- because both sides of the trade are counted. the funny thing is now people are freaking about the size of the carry trade even though one of the supposed culprits of the unwinding of carry trades last april/may (incorrectly) -- a drop Japan's monetary base from the BOJ ending quantitative easing -- is still shrinking 21% yr/yr. and other BIS data -- reporting banks' cross-border positions vis-a-vis all sectors, by domestic and foreign currency -- shows no explosion of yen liabilities among major global banks.
reporting bank yen cross-border positions vis-a-vis all sectors (blns USD)
liabilities
Dec04 Dec05 Jun06 Sep06
240.9 243.6 266.8 235.9 -- domestic currency
433.1 457.2 456.6 457.6 -- foreign currency
so we know the IMM speculative yen short data, we have a vague since carry trades are popular. but as the wachovia anlaysis points out (http://www.wachovia.com/corp_inst/page/0,,13_54_1069,00.html), the evidence is far from compelling. and funding CDO equity tranches in yen? i think holding/hedging those tranches is risky enough that involving another element like the yen would draw laughs from any risk manager. that is where gillian tett is getting carred away herself. where are the links between the yen and interest rates? check into PRDC or TARN structured notes that are popular among the japanese for yields, but have also spread to a wider array of investors. also, no one seems to mention the role of japanese FX margin trades in the carry trade. check out data from the Tokyo Financial Exchange, which gives just a small peek into the explosion of margin trading here. these margin traders are quick to take profits when cross/yen hits new highs, but also buy the higher-yielding currencies (like the Aussie, on serious leverage) on any sharp pull-backs. and since so much money is waiting in japan for moments of yen strength to invest abroad, it tends to put a floor under not only dollar/yen, but also euro/yen and sterling/yen. not to mention the huge outflow from japan last year related to M&A (such as japan tobacco buying gallaher, softbank buying out vodafone).
there are a lot of factors at play. but it seems oh so easy to chalk everything up to the carry trade or global liquidity. which is just how financial journalists (and even many of the commentators they quote) oversimplify the world and spread more confusion than clarify around such issues. this is when it really helps to talk to a friendly risk manager.
that's my 2 cents. (or 1 yen). cheersWritten by tmcgee on 2007-02-04 04:25:54well saidWritten by Guest on 2007-02-04 05:33:11Dear tmcgee,
The fact that yen cross-border positions are basically unchanged, while yen FX swaps have exploded by 65% in 5 yrs. should tell you that the swaps are being done locally and are not due to cross-border import/export commercial hedging activity. This, once again points to speculation.
And while BIS data are in fact corrected for double counting, the rate of change of 2A is the same as for A, anyway.
Dumping the whole current "liquidity" situation onto the yen carry trade is, of course, not appropriate. It is only a factor in a bigger story, not the whole story and the net must be cast much wider, as even $1 trillion in carry trades would not account for the credit explosion of the past 4-5 years.
RegardsWritten by Hellasious on 2007-02-04 08:50:24
Former European Central Bank Chief refutes US Federal Reserve on credit explosion of the past 4-5 years fueling Asset bubbles - Dave C.
“European Central banks are now realizing they must take global levels of liquidity seriously, the ECB’s former chief economist, Otmar Issing, said Friday. ‘I am concerned about excessive liquidity in the world,’ Issing told a conference for economic students here. This concern is shared by the current members of the ECB’s Governing Council, who have taken the lead in alerting other central banks to the risks at hand, Issing noted. ‘There is now increasing support of the view that excessive liquidity world-wide is fueling asset prices and is something which has to be taken seriously by central banks…This is a real concern.’”Written by Dave Chiang on 2007-02-04 09:48:32If we were to expand our definition of yen carry trade to include not just professional leveraged players with speculative positions, but also local day traders and Japanese households seeking higher yield overseas, then the US$ 1 trillion number is by no means ridiculous. One way to put this discussion in context: Japanese household financial assets constitute JPY 1,500 trillion, or US$ 12.5 trillion at the exchange rate of 120. If only 2% of these assets were invested overseas to earn higher yeild, that alone would constitute a quarter of a trillion dollars...
For data on Japanese household financial assets, see page 33 of the following presentation from Nomura Securities:
http://www.net-ir.ne.jp/webcast/ir/061204/02/628e5751b2/061204ppt_en.pdf
Regards,
AndrewWritten by Andrew Rozanov on 2007-02-04 10:30:21Leveraged day traders out of Japan (margin trading) has been a big source of outflows, along with institutional money. Tis true that the leveraged margin players have tended to buy on dips, but their behavior in a 98 style correction also hasn't really been tested. and that is in some sense where I suspect expectations of Japanese intervention in the face of any big move come in -- it puts a floor under the losses of various leveraged players, domestic and external.
Funding an equity tranche in yen would be a bit extreme, but then again, I really don't understand all the various ways that i-banks have tried to hedge the risks that they have to hold as a byproduct of the securities that they are creating -- i.e. you splice and dice and are left with some bits where there is a bit less demand in order to create the stuff that people want. Rajan (imf's departing research director) seemed convinced that a lot of these pieces were being held on the balance sheets of the big i and commercial banks ...Written by bsetser on 2007-02-04 11:04:43The $1Trillion (or more) would not surprise me at all. It's the difficulty of determining what that means. Tett's recent reference to her 'chilling email' portrays her as someone who is more enamoured with sensationalism than analysis.Written by Guest on 2007-02-04 12:03:54
Despite what we may all say, the US Treasury Dept. (and perhaps the Fed, too) are in no hurry whatsoever to stop the carry trades.
a) Paulson may "talk" to the Chinese about revaluing the yuan, but takes absolutely no action. The dollar is dropping against EUR and is thus helping exports (as 4Q06 GDP showed), but the yuan in pegged and thus Chinese goods are still dirt cheap. Ergo: export competitiveness PLUS low domestic inflation. Win-Win.
b) The yen carry trade provides liquidity to prop up global financial markets where US financial institutions reap huge profits, plus helps in financing the US debt. Geese bearing golden eggs do not get slaughtered for their meat.
c) While the EU tries to talk the yen higher, Paulson was just quoted as saying that a low yen "reflects fundamental characteristics - low interest rates in a country fighting to escape deflation".
It all boils down to this: Unless the rest of the world can do it, the current US administration will not willingly unravel the carry trades. It is too intimately tied to financial interests that do not wish to see the party end.