Yen Carry Trade

Last nite the Bank of Japan (BOJ) continued to pour 'liquidity' into Japanese financial markets. Total money printing over the past three days has been nearly $700 billion worth of yen. That amount exceeds the objective of the Fed's QE2 program.

At first glance, one would expect the yen to be hammered by this massive wave of money printing. However, the yen is actually higher over the past couple of days.

How can this be? Over the past few years people have been borrowing yen from the BOJ at ultra cheap rates and using the proceeds to speculate in stocks, bonds, and other risky projects. This called a carry trade--borrowing at cheap rates and investing in a project with a higher rate of return. The idea is to make money on the spread between the cost of 'carrying' the cheap loan and the return on the risky project.

The risk to carry trades is that either a) borrowing costs rise or b) returns on risky projects decline. When either occurs, carry traders sell their risky projects and seek to buy back currency in order to pay back their loans and reduce leverage.

Right now, investors want out of risky projects that were funded with borrowed yen. They are effectively short the yen, and to cover their short position they need to buy yen, which is putting upward pressure on price due to higher demand.

Once the urge to close out carry trades sets in, herd mentalities of risk aversion can make this behavior persistent.

It should also be mentioned that carry trades funded by US dollars have increased dramatically over the past couple of years as investors have been exploiting ultra cheap rates offered by the Federal Reserve.

no positions