Yen Carry Trade Doesn't Need the Dollar

For many months I've been discussing the role of the Yen Carry Trade in perpetuating global economic imbalances. Recently the issue has been getting more attention in the mainstream media. The point I'd like to make now is that the Yen Carry trade appears to be shifting more toward currencies other than the US dollar, like the pound, the euro and the New Zealand and Australian dollars.

When the Fed lowered short term US interest rates to a mere 1% in 2003 it sparked a rise in the carry trade in the US. As the Fed moved rate up from 2004 into 2005 it made the cost of borrowing in the US too high:



By early 2005 carry traders had begun looking to Japan as their source of cheap short term borrowing, but this also required traders to sell the yen they borrowed in order to buy dollars. The following chart shows the effect this has had on the Dollar/Yen relationship since late 2004 (blue), and how the dollar has done against a broader range of currencies (black):



As long as the fed kept raising rates, the dollar stayed strong. When the Fed stopped raising rates in the middle of 2006, the dollar began declining against most world currencies. However, the Yen itself has been kept weak as the Bank of Japan has been very reluctant to let a strengthening Yen cut into Japanese manufacturing profits.

While the Fed has been reluctant to raise rates, for fear of toppling the various debt pyramids in the US, other central banks have recognized a need to fight inflation and have been continuing to raise rates. Recent efforts in Japan to talk down the Yen have had a more pronounced effect on the Yen Carry Trade with other countries, resulting in the Australian Dollar surging to a new high against the US dollar (among other notable movements). As these carry trades flourish even further, the relative importance of the Yen/Dollar carry trade becomes less of a concern. Japan wants a weak currency, but it can allow some strength against the dollar in exchange for weakness against everything else.

In spite of the wide expectation that the Fed will lower rates later in the year due to a softening economy, I believe that the Fed is more concerned about the status of the dollar. The recent rise in inflation will probably give the Fed an excuse to talk up the need for keeping rates up. We'll see later today how they go about doing this and how the market reacts. The world is very slowly realizing that it can (and will have to) grow without the US consumer as its primary customer. At the same time, speculators are coming to realize that there are better ways to play the carry trade than to expose themselves to the tremendous risks of investing in US dollar denominated assets. Rates in the US will likely rise as attracting capital becomes more difficult over time.