Interest Rate Roundup

Thursday, March 01, 2007

Watch that Yen Carry Trade ...

One major force behind the asset inflation we've seen in the past few years is the yen carry trade -- everybody and his grandmother borrowing cheap money in Japan (where interest rates were near 0% for many moons, before climbing first to 0.25% and several days ago to 0.5%) and investing it in other asset markets overseas. Treasuries. Corporate debt. Commercial real estate. Stocks. Any and all assets were fair game for this easy money. This post talks about it in more detail.

Then this week, that started unravelling. Maybe it was a delayed reaction to the Bank of Japan's 25 basis point rate hike on February 21. Maybe it was something else. But all of a sudden, as if a switch was flipped, the yen started surging -- more than 2% on February 27 and more so this morning (recently 0.7%). That, in turn, has sparked a wave of selling in all kinds of asset markets, plus a flight to quality bid in Treasuries.

I hate to raise the spectre of it, but the last time we saw similar circumstances to this, it was 1998. That's the last time a blow up in the mortgage lending market (due to 125% LTV loans then ... vs. overall subprime lending now), an unexpected surge in the yen, carry trade unwinding, a sudden re-assessment of risk, and other forces converged to cause the markets to go haywire. You may recall a certain hedge fund named Long Term Capital Management blew up as a result, and the Fed had to organize a bail out.

Things aren't that bad yet today, and maybe they'll never get that way. Japan's top currency official, Hiroshi Watanabe, is on the tape saying he believes any impact from carry trade unwinding will be "somewhat limited." But I can't help but mention the eerily similar circumstances we're seeing today vs. 1998.


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