Gold, the Yen and subprime
Today’s post is a bit of a public service, as most techies will have little awareness (justifiably) about the “Yen carry trade”. But this short research summary from the RBC Capital Markets research teams (in both Toronto and Sydney) is a great primer. It reminds all of us how little we, as individuals, truly know about the global capital flows; but it is also further proof about the ability of a credit shock in one part of the market to weigh down on another.
“Gold Price Impacted by Yen Carry-Trade
Over a 2-week period in late February/early March 2007, the US dollar and the gold price weakened simultaneously, in contrast to their historically strong negative (inverse) correlation. We explained this unusual relationship in our report entitled Global Gold Outlook: A Pause – Then Re-Test $725/oz Before Year-end – (March 30th 2007), and highlighted the adverse impact that the unwinding of yen carry trades appears to have on the price of gold.
Speculative investors, motivated by interest rate differentials between Japan (with low rates) and other countries, look to profit by shorting the yen, on the belief that interest rate differentials are a key driver of currency values. Yen appreciation currencies such as the USD can trigger the need for these speculators to cover their short positions, in turn requiring that
yen-denominated investments be sold, which is commonly done through the sale of yen-denominated Nikkei futures, or gold futures on the Tokyo Commodity Exchange (TOCOM). This margin covering results in downward pressure on gold and the Nikkei.In the opposite scenario, when the yen depreciates versus other currencies, a corresponding rise in the gold price and Nikkei can occur, as carry-trade investors redeploy margin to increase existing long Nikkei and gold futures positions.
Concern over U.S. sub-prime rates and stronger-than-expected Japanese retail sales have led to yen strengthening (USD weakening) and reduced yen carry trade activity. This week, the yen (in USD terms) has appreciated from 123.9 to 122.8, while gold has declined
from $654/oz to 643/oz.As a result of our thesis regarding this interaction between the yen, USD gold price and Nikkei, it comes as no surprise to us that price movements between the three instruments show strong correlation.
Implications.
Although yen carry-trade activity is just one of countless influences on money flows into and out of the gold market, the dynamics associated with it appear to have a significant impact on the recent decline in the gold price. Continued yen strength over the next several weeks would lend further support to our thesis that gold will drift lower early this summer, to a
range of $625 to $635/oz, before strengthening due to fundamental seasonal
gold demand in the late summer/early fall period.”
Got that? U.S. subprime concerns help stir a rally in the Japanese Yen. Temporarily driving down the price of gold. Who knew that Bear Stearns (BSC:TSX) was so influential as to impact one of the largest economies in the world?
MRM
Here is some more interesting commentary on the Yen Carry Trade by one of your valued partners…
Blame the Yen Carry Trade – May 23, 2007
By Stephen S. Poloz, Senior Vice-President, Corporate Affairs and Chief Economist, Export Development Canada
Is your currency rising unexpectedly? Blame the yen carry trade! Can’t figure out why copper prices are so volatile? Blame the yen carry trade! These days, the yen carry trade is being blamed for everything, and is popping up in everyday conversation.
The yen carry trade can take on a variety of forms, but at the heart of each is a loan taken out in Japanese yen, the proceeds of which are used to invest in financial assets elsewhere in the world. It takes advantage of the fact that Japanese interest rates are extraordinarily low, while other countries’ interest rates are much higher. For example, an investor can borrow yen from a Japanese bank, convert the funds into Canadian dollars, buy a Canadian government bond, and earn an interest rate spread of around 4%.
The best part of this investment strategy is that the investor makes a 4% spread return on the entire structure, most of which is not his money. He may be required to put up 5% or 10% collateral with the bank – essentially investing $5 of his own money to buy $100 in Canadian bonds, thereby earning a $4 return on just $5 invested, or effectively 80%. Layered on top of the structure is an expectation that the Japanese yen will continue to drift down while the Canadian dollar may continue to appreciate – another positive return.
Notice that the more yen loans that are issued, and the more they are converted into other currencies, the more exchange rates move in a direction favourable to the underlying investors. In other words, exchange rate movements are almost inevitably exaggerated by the use of these complex financial wagers.
How big a phenomenon is this? It is difficult to say but all indications are that it is very big. Data from the Bank for International Settlements in Basle, Switzerland (the central bankers’ bank) indicate that the use of these structures in foreign exchange derivative transactions has risen significantly in the past couple of years. Notional outstanding values are estimated at around $40 trillion. That should be compared to average global daily turnover in the foreign exchange market of about $3 trillion, which truly is colossal. But global GDP is only about $40 trillion.
The problem with these structures is the potential for an abrupt unwinding of positions. An investor who decides to take his $5 out of the market sells $100 in Canadian bonds, sells $100 of Canadian dollars, and buys yen to close his position. Accordingly, a shift in expectations about monetary policies or currencies can lead to a very rapid evaporation of positions and huge moves in exchange rates.
The bottom line? The yen carry trade is a legitimate tool for many financial institutions. But, like many synthetic financial structures, its over-use as a wagering tool runs big risks, both for the investors and for the global financial system at large.
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The views expressed here are those of the author, and not necessarily of Export Development Canada.