Futures: The Easiest Way to Play the Yen Carry Trade

Tired of seeing hedge funds have all the fun? Want to play the Yen Carry Trade (YCT) like the big boys? Well, all you need is a futures trading account and you too can make huge, leveraged bets that the dollar will stay strong against the Yen. Of course you'll get wiped out like the rest of them if the Yen gets stronger in a hurry.

Here are some quotes for the Dollar/Yen on the New York Board of Trade futures markets. Notice that:
the June '07 contract closed at 121.325 Yen to the Dollar, while
the September '07 contract closed at 119.925,
the December '07 contract closed at 118.610, and
the March '08 contract closed at 117.360.

These prices reflect the interest rate differentials for Yen and Dollars. If you sell Yen by purchasing any of these futures, and the Dollar/Yen exchange rate remains constant, then the value of your futures will gradually rise over time. Buy enough futures contracts and you'll have a highly leveraged bet on the Yen appreciating relative to the dollar at a rate less than 4.5% per year. Here are some Yen/Dollar contracts graphed:



When you buy (Dollar/Yen) or sell (Yen/Dollar) the appropriate futures, the counterparty is typically a large banking institution like JP Morgan, Citigroup or Goldman Sachs. The big banking houses will usually then hedge their futures positions by borrowing actual Yen and then selling them for dollars on the Foreign Exchange markets. Together with the banks, your trades will amount to a full blown YCT that helps prop up the dollar and fuel America's excessive consumption.

The difference in Japanese short term rates (0.5%) and US short term rates (5.25%) is generally enough for the commercials to score a nice profit on the fully hedged position. If the exchange rate stays constant, you get around 4.5% with considerable risk, while they get around 0.25% with little or no risk. Of course fees, commissions and spreads cut into everyones profits. The numbers above are just for illustrative purposes.

Here's a nice chart showing the open interest as well as the relative positions of commercials and large and short speculators as reported to the Commodity Futures Trading Commission:



A year ago, Open Interest in futures contracts was low and the Commercials had gone short the Yen after a big unwinding of the YCT. Since then there's been a substantial increase in the size of the YCT, as reflected in futures positions, with two notable dips along the way (Oct-Nov & Feb-Mar). Neither of those dips in YCT positions was enough to push the commercials into being short Yen futures, but both coincided with sharp drops in the dollar relative to the Yen:



The Yen has been trending down against the Dollar since the beginning of 2005 when the interest rate differential between the US and Japan got large enough to make the YCT attractive. With commercials again very long Yen futures and rates more stable of late, it appears that the Dollar is poised for another sharp decline relative to the Yen. Of course the YCT could get more overextended before the next decline begins. Betting against the YCT can result in a very long, painful waiting game, as most small futures speculators have discovered this year.

Japanese Investors and the Yen Carry Trade

Japanese retail investors have become very active in the Yen Carry Trade, helping to keep the value of the Yen suppressed for now. Here are some interesting quotes from a Bloomberg article:

Trading of currencies in Japan using borrowed funds rose 41 percent in the first quarter to 109 trillion yen ($896 billion), exceeding 100 trillion yen for the first time, the Financial Futures Association of Japan said.

Japanese individuals' trading volume accounts for 20 percent to 30 percent of the interbank foreign-exchange market in the Tokyo time zone,'' Fukaya said. "They are also active in London time after going home. They are becoming a rival to be reckoned with for institutional investors.''

The rise of the carry trade among Japanese retail investors is a good indication that it won't continue much longer. When retail investors arrive on the seen it provides cover for the bigger players to exit. To the average retail investor what's been working lately will probably always work. They here their friends boasting about their easy profits and they hop aboard the train, not realizing the risks they face if their highly leveraged bets go bad from a rising Yen. Just as marginated Nasdaq investors got cleaned out quickly in the sharp decline of early 2000, I expect that many japanese retail investors will have their accounts purged early in the game when the Yen Carry Trade starts to unwind. When it does, over a hundred trillion Yen could potentially be subtracted from the money supply to pay off margin debt. In the meantime, it's the YCT is providing a lot of interest income and trading fees for Japanes banks and brokerages.

Lately the YCT has been working espeicially well for anyone playing it, with the Yen falling against the dollar adding to gains from interest rate differentials:

Next Stage of the Housing Meltdown

It took the homebuilders a long time, but they may finally be figuring out that they're in for a long, painful downturn. Their problem all along has been that they were building far to many homes for the nation's needs. The homes were selling well, up until late 2005 as speculators bought homes to flip or rent out and baby boomers bought retirement homes in advance with the help of low interest rates. But just as those trends were reaching saturation, builders got greedy and greatly expanded their inventory of land and communities under development. Rather than hold off on development as buying slowed, they rushed ahead with projects in the hopes that the customers would return in large numbers. When that didn't materialize, it took a long time for most builders to figure out that they were facing a long term liquidity crisis based on having too much debt and inventory that they can't easily sell.

Judging by the April Existing and New Home Sales numbers, it appears that reality has finally set in and builders are slashing prices to move inventory. New Home Sales numbers were up substantially in April from the first three months of the year on much lower sales prices, and inventory of finished new homes was down as well:


We probably haven't seen the peak yet, as the biggest rise in finished unsold homes usually comes in the second half of the year, but it's progress. The current group of finished homes for sale have been completed for 6 months, up from 3.9 a year ago, suggesting that not as many new finished homes are joining the group and bringing down the average. Meanwhile, the median price of new homes sold fell from $257,600 to $229,100 likely reflecting big price drops to move inventory. (I've heard of $220,000 price cuts in the Sacramento area.)

If builders have finally shifted into price cutting mode then it shouldn't take long for price cuts to hit the Existing Home Sales numbers. Today's release reflects sales made a month or two ago, but the inventory numbers are current and they jumped from 3.806 million homes for sale to 4.2 million. With an 8.4 month supply sellers are going to have to get more aggressive if they want to unload their homes.

The biggest sellers are now the mortgage lenders who've had to foreclose on large numbers of homes. Countrywide financial had over 8,000 properties listed for sale on their site as of 5/22/07, with total listed prices over $1.5 billion. Looking county by county at RealtyTrac yields some amazing "bank owned" numbers (5,706 in Sacramento County, CA for example and 11,578 in Los Angeles county). These guys probably have the most to lose from a drop in prices, as they've mostly avoided taking charges throughout the mortgage crisis so far. Their ability to get financing depends on an appearance of solvency.

As we head into the next phase of the housing downturn, we should see prices decline more rapidly in most areas, with builders leading the charge, followed by desperate homeowners (there are enough of them still out there with equity to preserve if they can avoid foreclosure with a sale). I still expect most lenders to drag their feet on lowering prices, and the ones who are getting liquidated are most likely the ones bringing large numbers of homes to auction these days.

How Yen Carry Trade Benefits Japan

(I was asked about the unwinding of the Yen Carry Trade on another forum, so I wrote up this quick summary.)

Hedge funds playing with other people's money borrow Yen, which they'll eventually have to pay back with interest. As they buy dollars and other currencies with the Yen it drives the Yen down for now and helps Japanese manufacturers sell their goods.

It also creates profits for Japanese banks who normally have trouble finding enough Japanese to borrow money and keep the money supply growing. I estimate around $50 Trillion Yen have been created out of thin air by Japanese banks for Yen Carry Trade related borrowing. Interest on this new money is pure profit for japanese banks. Call it $10 Billion in profits annually for Japanese banks with other economic benefits as long as the carry trade continues.

The YCT is a Ponzi scheme with the BoJ acting as chief schemester. To keep the yen suppressed requires ever more borrowing of Yen to be sold for other currencies, which in turn leads to greater profits for the Japanese banks. Also, most of the trades entered into by hedge funds playing the YCT accept very high long term risk in order to maximize short term gain. Eventually, however, long term realities coupled with the weight of the Yen denominated debt and the will bring the majority of hedge funds playing the trade back down to earth. As the trade unwinds, the Yen rises and carry traders will lose out on the conversion back to Yen, resulting in a very large gain for Yen holders (i.e. the entire Japanese economy).

The BoJ tends to go for extreme economic interventions to benefit the Japanese banks. It pumped a huge amount of liquidity into the Japanese economy during the recession years, then drained it out during big carry trade years. The Yen created by the YCT sit in Japanese accounts waiting to be converted in to foreign assets when the trade unwinds. The BoJ can create as much new liquidity as it likes to offset the conversion of those Yen into foreign assets when the YCT unwinds.

There will likely be a very large economic shift when the trade does unwind. Japanese manufacturers will be at a huge disadvantage, but Japan will be sitting on monstrous amounts of foreign reserves. The Japanese consumer sector will likely take off as Japan adjusts to a much higher standard of living.

In answer to your question about the Japanese stock market, I'd expect the Japanese manufacturers with enough overseas production to do well, while those will all their production in Japan should have trouble. I'd also expect Japanese retailers and service providers to do well. For now, however, the YTC continues stronger than ever and the Japanese consumer sector has been weak.

These Stories Tell the Sad Story of the US Economy

The US economy is dying a slow painful death. The body is suffering as many consumers are buried under a mountain of debt, foreclosure rates are soaring and the housing market is awash with vacant homes that can't sell.

Life support for this terminal case comes in the form of foreign purchases of US assets, the Yen Carry Trade and credit creation to increase leverage and risk in the business sector. The infusion of cash drives up profitability of US businesses, provides jobs and creates an illusion of financial health that can only be considered temporary.

Debt burdens are already at levels where they can only be serviced by the addition of more debt. Without foreign investment and rapid money supply growth the profitability of most American businesses would tumble. Without private equity capital, hedge fund borrowing and increasing corporate leverage the stock market would tumble. A look at the contributions of each of the leading economic indicators, gives a good "indication" of where the US economy is being led:

Negative or Flat Economic Statistics:
Average Workweek = -.06%
Initial Claims = -.12%
Vendor Performance = -.07%
Capital Goods Orders = -.08%
Building Permits = -.25%
Interest Rate Spread = -.06%
Consumer Expectations = -.08%
Consumer Goods Orders = 0%
Subtotal: -0.72%

Positive Stimulants:
Money Supply, M2 = +.12%
S&P 500 Stocks = +.15%
Subtotal: +.27%

Total Leading Economic Indicators: -0.45%

M2 and the stock market are being manipulated upward with easy credit and the huge flows of borrowed and foreign money into equities, which in turn is providing a great deal of short term economic stimulus. If not for this, all the other indicators would be down worse and the total measure of leading economic indicators would be pointing toward a very sharp recession.

Wall Street understands the sad state of affairs very well, but rather than seeking constructive reform of the financial system a feeding frenzy has erupted among the sharks circling the carcass. New money is being created to fund private equity deals at an accelerating rate and US assets are being sold off as quickly as Wall Street's dealmakers can find willing sellers. It's as if there is a mad rush going on to extract the most fees possible before the day comes when there's nothing left to plunder. The following articles give a snapshot view of how the flood of foreign and new money are propping up stocks and the economy for the time being:

1. Saudi Firm Buys GE Plastics for $9 Billion.
"General Electric Co. said Monday it will sell its GE Plastics division to petrochemicals manufacturer Saudi Basic Industries Corp. for about $11.6 billion.
GE said it would use the proceeds primarily to increase its planned 2007 stock buyback program. It now expects to buy back $7 billion to $8 billion in stock, up from the previous plan of $6 billion. The deal is expected to create a net gain, after taxes, of $1.5 billion for the conglomerate."

With hundreds of billions of US dollars to invest, oil producing nations are gobbling up bonds and equities on a massive scale. Meanwhile GE seeks to prop up their stock price and increase leverage through greater share repurchases. Credit problems at GE Capital may be beginning to put some pressure on GE's liquidity. Much of the money they receive from the Saudi's will probably get loaned out to other businesses through GE Capital. The Saudi's are letting us sell off our hard assets in order to fund excessive consumption of oil.

2. Countrywide Financial Raises $4 Billion.
"Countrywide Financial will use a portion of the net proceeds from this offering to fund repurchases of up to 23 million shares of its common stock simultaneously with this offering and expects to use the remainder for general corporate purposes."
It came from new convertible debt in a private placement and Countrywide will use around a billion of that to buy back stock. With defaults leading to a liquidity crisis for many lenders countrywide is trying to buffer their cash position with low interest debt at the expense of future share price appreciation.

3. China Takes a $3 Billion Stake in Blackstone.
"The agreement gives China's government a stake in the private equity boom sweeping the globe and hands a key alliance to Blackstone at a time foreign investors struggle to gain support from the Chinese government for takeovers of domestic assets."

Like the Saudi's, China is rolling in trade gap dollars and getting tired of piling them into US treasuries and agency debt. They're looking for investments that won't lose as much ground to inflation as faith in the dollar begins to unwind.


Every day seems to bring more stories like the ones above - money being created to fund share repurchases, US assets being sold to fund the trade gap. When the game comes to an end it sure won't be pretty.

China announced that they are widening the trading band for the RMB last week. That's a way of saying that they are going to let the dollar fall faster. As the Chinese are already accumulating far more dollars than they want, their choice is either to keep the accumulate more or let the dollar fall. I did a quick graph of each time the dollar dropped 5 fen (0.05 yuan) and the dollar has been faster lately:


In contrast, the dollar has been rising against the Yen over the past year:


I attribute the falling Yen almost entirely to a Yen carry trade that has gone completely out of control. When the market for high yielding, subprime mortgage backed securities (a favorite of carry traders) started to reflect the reality of the housing market back in February and March, the Yen strengthened initially but then came tumbling back down as carry traders increased the size of their bets. Against the Euro, the Yen's extreme recent weakness has been especially clear:


With the US bull market on it's last legs, the Dow Jones Industrial Average keeps making new highs. The recent strength of the large cap stocks relative to everything else suggests a desperate prop job:


The most successful hedge fund over the past two years continues to pile into stocks, and especially Dow stocks, the performance of the stocks they've chosen hasn't been good, but that doesn't really matter if the rising tide is lifting all boats and their leverage is high enough:



Renaissance is just one of hundreds of hedge funds borrowing Yen and buying up large cap stocks these days. As long as the game is working, they'll keep playing. Just don't expect it to go on forever.

How Big is the Yen Carry Trade?

In this article Japanese bureaucrat Hiroshi Watanabe says that there won't likely be a "hasty unwinding" of the Yen Carry Trade, and hints that the total size of speculative carry trades is around $100 billion, rather than $1 trillion as some estimate. I'm skeptical of these claims, as I believe the YCT suits the profit motives of Japanese bankers very well for now. It's also providing cover for the Bank of Japan to reduce its US treasury holdings, and if the trade doesn't keep expanding, then the demand it is creating for trade gap dollars and new US debt will disappear, pressuring the Yen back up, which doesn't suit the Japanese government's political motives very well at the moment.

To try and get an idea of how big the YCT has become I took a look at grwoth in various portions of the Japanese money supply:


Based on an exchange rate of 120 Yen = 1 Dollar...
From April of 1998 to April of 2001 Japanese M2+CDs grew $471 Billion, while M3+CDs grew $636 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $1,020 Billion.
From March of 2001 to March of 2004 Japanese M2+CDs grew $956 Billion, while M3+CDs grew $61 Billion (meaning non-M2 components of M3 declined sharply) and Broad Liquidity grew $328 Billion.
From March of 2004 to March of 2007 Japanese M2+CDs grew $281 Billion, while M3+CDs grew $626 Billion, and Broad Liquidity grew $902 Billion.

As I read it, the Japanese government and Bank of Japan were busy running up debt and stuffing money into people's pockets as an attempt to stimulate the economy during the recession years of 2001-2003. Since then they've been draining liquidity, but the Yen carry trade has picked up the slack, causing the total money supply to grow much more rapidly.

For the $100 billion estimate to be true, domestic Japanese credit expansion would likely be responsible for the bulk of the surge in broad money. For the $1 trillion estimate to be true the Yen carry trade would likely be making up for a several hundred billion dollar liquidity drain by the BoJ. My own hunch is that the total amount of borrowing in Yen for speculative carry trade bets by investors outside of Japan is probably over $500 billion. On top of that, the amount of official Japanese money invested abroad is about $1 trillion and there may be another $1 trillion in private Japanese money invested abroad.

The borrowed money for speculative purposes is quite a racket for Japan, where a portion of global investment returns are steadily cyphoned off by Japese banks. Watanabe doesn't forecast a "hasty" unwinding, but a slow and painful unwinding would be just as bad for the pension plans and other investment pools run by global hedge funds. Keeping the slow bleed going forever is probably plan A. Japan has the ability to stuff liquidity back into the system, just as they did during 2002-2004 in a way that can keep the Yen's rise unhasty. Foreign borrowers will have to pay back their Yen loans at a greater cost than they bargained for if the BoJ handles things in the best interests of Japan. Western politicians and bankers play along because for now it means a stimulated economy and short term profits.

If plan A fails, and some systemic shock causes a sudden rush by carry traders to get out, then plan B, a hasty rise in the Yen and forced liquidation of foreign carry traders probably works out best for the Japanese as they wouldn't want to let foreign hedge funds get off too easily. After a thorough cleansing of the trade I could see the BoJ rushing back in with another round of liquidity to return the Yen to manufacturing friendly levels. With the Yen near four year highs, entering new carry trades is probably an especially bad idea around now, and its not surprising to see the Watanabe trying to be more encouraging of sucker bets. While he says that the trades "won't be unwound in a hasty way," the 20% rise in the Yen we saw in 1998 would work very well as part of plan B today.

The Yen Carry Trade has been a big part of global economic imbalances and like the rest of the imbalances I believe it must eventually come back into balance one way or another. As we see the rebalancing process taking hold via a strugling US economy and declining US consumer purchasing power, I expect we'll also see a big drop-off in US investment returns as a result of either a gradual or "hasty" unwinding of the carry trade.

A Possible Rate Cut Next Wednesday?

The Federal Open Market Committee meets next Wednesday, and I haven't heard any speculation out there about a rate cut on the Fed Funds target from 5.25% to 5.00%. However, the daily Repo rate has been below the target for the last two weeks. Today it was 5.06%, with somebody having the nerve to bid 4.98%. I personally take this as a signal to the Fed that certain banks want short term rates lowered.

The member banks want lower rates and a normal yield curve. Inverting the curve was fine and dandy for squeezing out competition from the subprime lenders, but now big banks are getting in trouble too. They'd like to cut the rates they have to pay depositors and boost the rates they collect from borrowers. That will restore some profitabilty to their core business to offset some of what they are losing through defaults.

A Fed Funds rate cut would not be good for the dollar, although it's the higher yielding long term securities that matter the most for carry traders. If longer term yields fall (boosting the price of securities) it helps those already in carry trades, but it discourages new traders for entering into them and sucking up supply of trade gap dollars. That could lead to a falling dollar, much higher long term rates and a falling stock market.

Up until now, the Fed has been on the side of protecting the dollar and US banking profits tied to the Yen carry trade. If the Fed goes through with the rate cut next week or at the June 27/28 meeting we could be in for some dramatic changes in the rebalancing process.