Unravel the secrets of the yen carry trade Mon Apr 23, 2007 9:04 AM BST163 By Alan O'Sullivan LONDON (Citywire) - It is a phrase that has been creeping into economists' pronouncements for months, the risk of the âyen carry trade unwinding'. But do fund selectors have any cause for concern? When market volatility hit in February, the yen carry trade was one of the culprits at which economic analysts initially pointed the finger. The trade refers to a strategy in which yen is borrowed at near zero interest rates, converted to another currency and then invested in that country's assets. The âcarry' refers to the profit that can be made between the cost of the yen and the income from those assets. Keeping this in mind, there are several signs managers need to look out for if an unwinding of the trade were to take place. Firstly, a rise in Japanese interest rates would clearly reduce the profitability of this trade by reducing the positive spread between the cost of funds and the income they generate. But there is also an asset price risk, depending on whether the balance of the trade is invested in bonds, equities, real estate or commodities. If there is a fall in global liquidity, then the assets that benefited from the rise in liquidity will fall. The carry trade could also be brought to a standstill if the Bank of Japan decides to increase the reserve requirements for Japanese banks, which drains liquidity from the system and forces investors to liquidate assets prematurely. However, some believe these fears are an unnecessary preoccupation. Standard Life's head of global strategy Andrew Milligan says: "I have yet to see any evidence that a classic yen carry trade is large or important. When you go into the figures as to where people have been borrowing from, the sums from Japanese banks are not particularly large." He refers to a recent report from leading Japanese bank Nomura , which states that the inability to quantify reliably the degree of leverage in yen carry trades suggests that the fear factor could have had more of an influence over markets recently than the reality. "A disruption of a couple of billion dollars is not going to bring down global markets when compared to the S&P500 index, the market-cap of which is about $12 trillion (6 trillion pounds)." Currency analyst at HSBC David Bloom believes that any dip in the carry trade is merely a reflection of risk aversion in global markets and a result of the weakening dollar. "A true carry unwind is an irrational closing of positions due to fear," he says. "What we are seeing with dollar-yen at the moment is a rational result of reduced expected returns.! He terms concerns over a fall in the dollar/yen carry trade a "red herring" that reflects reduced expected returns in the US and points out that the dollar-yen decline makes perfect sense, given the move that the market has seen in recent months in US short rates. He says: "The yen is a consequence of the reassessment of the US economy and the global growth story and not a cause. Perversely we would argue that the move in dollar/yen is rationally fitting in with both the macro-environment and the general reduction in risk." Whether the carry trade is significant or otherwise, Citywire AA-rated Jan Luthman, manager of Walker Crips' UK Growth and Equity Income funds , has another calming message for the market. "People go on and on about the yen carry trade and at the end of the day it's all just posh borrowing. The big worry is not that yen interest rates go up, the worry is that the yen itself will go up. We may have to pay more and that could become a self-energising spiral because investors would then start selling off the things they had bought." However, in a worst case scenario, he believes central banks would step in to offer unlimited credit lines to major institutions so they can unwind their positions in an orderly way: "If you provide liquidity, then some will go bust but not everyone. There would be a lot of pain in an unwinding of the yen carry trade but we have been there before." (c) Citywire Financial Publishers Ltd 2007.