FTAlphavilleFT Alphaville is a 2008 Webby Award Winner

• News
• Markets Live

It was only in September that forex analysts were remarking on the return of the yen carry trade as the Japanese currency weakened after a brief bout of strength sparked some carry-trade unwinds earlier in the month.

Now, quietly, suddenly, the yen has become the world’s strongest currency during the global deleveraging process – and seems set to strengthen further.

The Japanese yen has a well established tendency to depreciate slowly while appreciating rapidly, but even then, the speed of recent yen appreciation has surprised even the most seasoned investors, notes Tohru Sasaki, JPMorgan’s Tokyo-based currency strategist.

In the space of two months – since mid-August – the yen has appreciated against the Australian dollar by 30 per cent and NZ dollar by 20 per cent (two favourite carry trade currencies); as well as the euro by 15 per cent and against the dollar by 10 per cent.

And given recent signs of waning Japanese investor appetite for the carry trade, yen strength looks likely to stay for the short to medium term, adds Sasaki.

Although it’s impossible to pinpoint the exact cause of the sudden, sharp yen appreciation, he notes that it coincided with the acceleration of the decline in emerging markets and growing fears about the fate of the US government sponsored enterprises Fannie Mae and Freddie Mac.

One possible explanation is that the problems faced by the GSEs triggered a withdrawal from the emerging markets – some of which were funded in yen borrowing, which in turn, led to the beginning of the unwind of short yen positions.

There are several aspects to the yen carry trade which should be noted, including retail margin clients, investment trusts, pension fund holdings and foreign retained earnings, he says

The common focus is the retail margin traders (ie, Mrs Watanabes of the world) who have collectively reduced short yen positions by 50 per cent from the peak in September to $24bn.

But margin traders makeup only a small part of the investor base. As of end-June, Japanese households hold an equivalent of $134bn in foreign securities (which include “uridashi” [foreign currency-denominated] bonds and stocks).

In addition, Japanese investors (including retail) held an equivalent of $336bn of foreign currency denominated investment trusts as of end-August. While we do not expect a wholesale liquidation on the part of Japanese retail investors, daily data indicates a small but continuous liquidation
of the foreign currency denominated investment trusts since September 12.

But forget the archetypal carry-trading Japanese housewife for a moment. Japanese investment trusts, insurance companies and pension funds hold approximately $1,300bn in overseas assets.

Though Sasaki does not expect massive waves of yen repatriation from Japanese companies, he says small changes in Japanese corporate hedging strategy and smaller capital outflows from Japan could easily see USD/JPY hit Y95 near term. But, he says, government intervention is still unlikely at this level – or even closer to Y90.

Overall, yen strengthening could be a theme over the coming months, given another likely wave of capital inflows from the retained overseas earnings of Japanese corporates (which Sasaki estimates at about $200bn). These foreign currency holdings can be attributed mainly to tax accounting reasons, and in part to the yen’s historical weakness and the relatively attractive foreign yields, he notes.

The impact of a planned Japanese government move to amend the tax code, to grant exemptions to overseas earnings repatriated to Japan and so, encourage earnings repatriation, could be substantial.

But corporates are likely to wait until the tax changes become law in April 2009, at the earliest. On the other hand, if the yen continues to appreciate, the yen-equivalent capital base of these overseas retained earnings will further diminish.

Correspondingly, these overseas earnings can be viewed in terms of a carry trade which is long a basket of foreign currencies versus the yen. From this perspective, the potential exists for foreign earnings to be repatriated at short notice, should the yen appreciate further.

One more point from Sasaki: earnings announcements by the US and European banks are scheduled in the coming weeks, and high volatility in the market is likely to further drive up the yen.

Meanwhile, the outlook for the dollar is suprisingly positive, according to another currency strategist, Richard Grace of CBA in Sydney, who says that despite the positive European initiatives after the weekend G7 meeting, demand for the dollar is likely to remain firm as institutions continue to scramble for dollars to: (1) meet USD funding requirements; (2) match USD assets and liabilities, and; (3) address necessary capital adequacy ratios in tandem with government support.

To date the demand for dollars has been strong enough for nine central banks, in conjunction with the Fed, to provide up to $620bn of USD swap lines, and it’s unlikely these lines will be reduced in the immediate future, notes Grace.

Despite the eurozone initiative to guarantee new bank debt issuance until end 2009, term funding for USD is likely to remain in demand. The demand for medium-term USD funding, as demonstrated in the foreign exchange forward market for AUD/USD should ease, but remain stretched
when compared on a historical basis.

In sum, volatility as measured by 3 month option vols. is likely to ease somewhat. But foreign exchange markets can be expected to remain range bound until confidence is restored and the mechanics of the government’s efforts prove to be effective enough for credit growth to pick up.