Complex Made Simple

Yen-carry trade: Game over?

This coming year the euro could strengthen against the Japanese yen. The present low Japanese interest rate of 0.5%, combined with a higher European interest rate of 4%, has fuelled demand for euros. Of course the yen has also weakened against other 'high interest' countries like Australia, New Zealand and the US.

Many investors have set up so called yen-carry trades: this involves buying shares/investing in assets in high yielding countries, which is funded by selling yen at a low interest rate. The Japanese currency is often borrowed to purchase assets for higher return.

This carry trade game has been played, and can be played, for as long as the return on investment is higher than the cost of financing. In other words, if, for instance, the prices of the acquired assets drop or the cost of funding rises (for example, the yen strengthens or interest rates rise), then investors have to, or are forced to, close their positions. This creates selling pressure on stocks and drives the Japanese currency higher.

Credit crisis

In 2007 the US credit crisis has been the big theme and a nightmare for many market players. When US and European stock markets tumbled in July/August and to a lesser extent in November, we witnessed a stronger yen: the euro fell 10% against the yen from 168 to 150.

In addition, during the summer, precious metals and oil prices dropped severely mainly because of the ‘carry trade effect’. Of course, the fear of slower world economic growth also put pressure on commodity prices.

This week the yen rose against the euro as a decline in global stocks, over concerns that credit market losses may deepen, reduced demand for high-yielding assets funded with loans in Japan. Speculation that the recent central bank injections into the money markets may not actually be enough to ease the global credit squeeze also played a role. This is a tasty cocktail which could give ‘carry traders’ a headache.

Charting future moves

The weekly chart of the euro/yen future shows an interesting development in 2007: lower highs and higher lows. This is a so called consolidation pattern. For the short term, the key levels are 164 and 162. If the euro/yen breaks one of these levels, we can expect a significant move. I expect that there is a big chance that the 162 support level will break in the coming weeks.

If so, then we can expect a fall of the euro/yen towards the next support level around 160. If this also eventually breaks, we can expect a sell off towards the 150 level. In that scenario, the stock markets will also show a brutal sell off. In my opinion, there is a little upside potential for the euro until 164/166.

Conclusion

At this moment, I prefer to sell the euro short around a level of 162.85 for a ride to 160 and lower. A break of 160 could be a signal for a fall towards 150. If however the euro/yen strengthens above 165, I will cover my position, of course, and get out of my shorts.