Chartbook Contact: Sebastian Becker +49 69 91-3664 Global Risk Analysis The unwinding of Yen carry trades Some empirical evidence 3 2 1-1 -2-3 -4 October 31, 28 Many years before the sub-prime crisis hit global financial markets, JPY funded carry trades were said to be popular among investors that were willing to take risks. A yen carry trade describes a strategy in which investors borrow cheaply in JPY to invest in higher-yielding assets such as US stocks or Australian bonds. During times of strong global growth, abundant global liquidity, strong risk appetite, surging asset prices and low financial market volatility, yen carry traders benefited both from exchange rate gains and a positive interest rate differential. With the credit bubble having burst and spill-over effects spreading to the world economy, the Japanese currency has appreciated massively against most major currencies, in particular vis-à-vis the high-yielding Australian and New Zealand dollar. This appreciation can be attributed to higher global risk aversion and a shrinking interest rate differential of the JPY against major currencies. Although the Japanese economy is headed for recession and not at all doing better than most of its peers in terms of GDP growth, the interest rate differential should narrow further as the BoJ has only limited room to trim interest rates (the BoJ trimmed its overnight target call rate this Friday to.3%) while other major central banks are set to cut rates even more aggressively over the coming months. Although global yen carry trades are difficult to track, empirical evidence (as e.g. gauged by balanceof-payments data, net JPY future positions from the US Commodity Futures Trading Commission and foreign banks borrowing in Japanese money markets) suggests that the activity of JPY funded carry trades has clearly softened since mid-27. While the amount of foreign assets held by Japanese households shrank with the start of the credit crisis, it is not clear to what extent this reduction is due to yen appreciation and how much it is driven by net foreign asset selling. However, borrowing by foreign banks in Japanese money markets has decreased significantly. Moreover, US future markets moved from net short to net long positions in JPY. Given heightened global risk aversion and a further shrinking interest rate disadvantage, the JPY may trade sideways or even appreciate further over the short to medium term against the USD and the EUR even after its recent rally. However, the issue of the sustainability of the recent strength of the yen and the Japanese currency s long-term prospects are a completely different story. International Net net capital capital outflows flows to from Japan Japan have declined in 28 ytd JPY tr 96 97 98 99 1 2 3 4 6 7 8* FDI Portfolio Investment Other investment Current Account Net total outflows * year-to-date (as of August 28).. Sources: DB Research, Global Insight
2 Broad-based yen appreciation since mid-27 JPY per foreign currency 28 24 2 16 12 8 4 9 92 94 96 98 2 4 6 8 EUR GBP USD AUD NZD CHF Strongest appreciation vis-à-vis highyielders, smallest fall against Swiss franc JPY performance, Index: July 27 = 1 11 1 9 8 7 6 Jul-7 Oct-7 Jan-8 Apr-8 Jul-8 Oct-8 EUR GBP USD AUD NZD CHF Rising global risk aversion led to sharp yen appreciation 12 12 11 11 1 1 9 9 8 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 8 7 6 4 3 2 1 17 16 16 1 1 14 14 13 13 12 12 11 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 7 6 4 3 2 1 JPY/USD (left) JPY/EUR (left) VIX volatility on S&P options, % (right) VDAX, volatility on DAX options, % (right) Sources: Global Insight, Bloomberg Sources: Global Insight, Bloomberg Implied FX market volatility: High, higher, highest! 1-month implied JPY volatility vs other currencies, % JPY/USD exchange rate volatility has surged above 1998 highs 1-month implied JPY/USD volatility, % 8 7 6 4 3 2 1 USD EUR AUD 4 3 3 2 2 1 1 Jan-7 Jul-7 Jan-8 Jul-8 Source: Bloomberg 9 96 97 98 99 1 2 3 4 6 7 Source: Bloomberg October 31, 28
3 Recently, interest rate differentials between major economies and Japan have diminished considerably at the short end Spreads of 3-month interest rates over Japan, percentage points 9 8 7 6 4 3 2 1 99 1 2 3 4 6 7 8 Switzerland Canada Australia New Zealand UK Euroland US as well as at the long end of the yield curve Spreads of 1-year govenrment bond yields over Japan, percentage points.. 4. 4. 3. 3. 2. 2. 1. 1. Jan-8 Apr-8 Jul-8 Oct-8 Switzerland Canada Australia New Zealand UK Euroland US JPY has started to return to its long-term exchange rate fundamentals in terms of PPP 2 18 16 14 12 1 8 +1% -1% 6 Note: PPP = Purchasing Power Parity 4 86 88 9 92 94 96 98 2 4 6 8 Long-term average: adjusted for inflation differential PPP JPY/USD Yen gained on spike in FX volatility and shrinking USD (EUR) / JPY interest rate differential 1..9.8.7.6..4.3.2.1. 96 98 2 4 6 8 14 14 13 13 12 12 11 11 1 1 9 9 3-month USD-JPY interest rate differential, weighted by 1-month implied USD/JPY volatility (left) JPY/USD (right) Sources: DB Research, Global Insight, Bloomberg.6..4.3.2.1. 99 1 2 3 4 6 7 8 18 17 16 1 14 13 12 11 1 3-month EUR-JPY interest rate differential, weighted by 1-month implied EUR/JPY volatility (left) JPY/EUR (right) Sources: DB Research, Global Insight, Bloomberg 9 October 31, 28
4 US CFTC future markets JPY positions: From net short to net long 3, 2, Non-commercial net short positions at the CFTC, JPY bn (left) JPY/EUR (right) 2 18 2, 1, 16 1, 14 12-1 -1, 86 87 88 89 9 91 92 93 94 9 96 97 98 99 1 2 3 4 6 7 8 8 Sources: CFTC, DB Research Foreign banks have reduced their JPY borrowing in Japanese money markets 4 3 2 1 9 92 94 96 98 2 4 6 8 Amounts oustanding in Japanese money markets, JPY tr (right) Percentage share of foreign banks (left) Sources: BoJ, DB Research JPY funded carry trades have brought massive losses since mid-27 Returns from JPY funded carry trades (buy and hold strategy), Index: 1.1.26=1 13 12 11 1 9 8 26 27 28 Long basket: USD, EUR, GBP, AUD and NZD with equal weights. Short basket: JPY. Base currency: EUR. Source: Bloomberg 1 8 6 4 2 Japanese investors hold large stocks of FX assets 4 3 3 2 2 1 1 7 7 8 8 9 9 1 1 11 1 2 3 4 6 7 8 FX-denominated equities, JPY tr (left) FX-denominated bonds, JPY tr (left) Total FX-denominated assets, JPY tr (left) Nominal eff. exchange rate, Jan ' = 1 (right) Sources: Global Insight, Jap. Investment Trust Association Net capital outflows have decreased recently due to other investment/short-term loans International net capital flows to Japan 12-month trailing sum, JPY tr 3 2 1-1 -2-3 97 98 99 1 2 3 4 6 7 8 FDI Portfolio investment Other investment (e.g. short-term loans) Net capital flows October 31, 28
Portfolio investment flows still negative for now Net portfolio investment, 12-month trailing sum, JPY tr 2 1 1 - -1-1 -2-2 Still large net capital outflows from Japan to the rest of the world JPY exchange rates and net capital flows 2 2 1 1 - -1-1 -2-2 97 98 99 1 2 3 4 6 7 8 Net capital inflows, 12-month trailing sum, JPY tr (left) JPY/USD, inverted scale (right) Net consolidated claims of BIS reporting Japanese banks to RoW has surged USD bn 2, 2, 1, 1, 96 97 98 99 1 2 3 4 6 7 8 Total Equity securities Debt securities Bond notes Money market instruments 8 9 1 11 12 13 14 1 1 2 3 4 6 7 8 All countries Offshore centres Source: BIS, October, 23, 28. BIS data as of Q2 28. Developed countries Cayman Islands Net short-term loans have weighed on the yen for many years 11 2 12 13 14 1 1 1 16 17 18 - -1-1 -2 3 4 6 7 8 but rapid JPY appreciation against most major currencies JPY exchange rates and net capital flows 2 2 1 1 - -1-1 -2-2 JPY/EUR, inverted scale (left) Net short-term loans, 12-month trailing sum, JPY tr (right) Sources: DB Research, Global Insight, Japanese Ministry of Finance 97 98 99 1 2 3 4 6 7 8 Net capital inflows, 12-month trailing sum, JPY tr (left) JPY/EUR, inverted scale (right) Is the recent fall of the JPY/EUR exchange rate due to a fall in foreign lending? 4 4 3 3 2 2 1 1 1 2 3 4 6 7 8 8 9 1 11 12 13 14 1 16 17 18 18 17 16 1 14 13 12 11 1 9 8 Consolidated foreign claims of BIS reporting Japanese banks to offshore centres, USD bn (left) thereof: Cayman Islands, USD bn (left) JPY/EUR (right) Sources: Global Insight, BIS, October, 23, 28. BIS data as of Q2 28. October 31, 28
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