Will the Fall in the US Dollar Affect the Carry Trade Currencies and the Global Markets?

``But when people discuss chance (which they rarely do), they usually only look at their own luck. The luck of others counts greatly. Another corporation may luck out thanks to a blockbuster product and displace the current winners. Capitalism is, among other things, the revitalization of the world thanks to the opportunity to be lucky. Luck is the grand equalizer, because almost anyone can benefit from it. The socialist governments protected their monsters, and by doing so, killed potential newcomers in the womb”- Nassim Nicolas Taleb, Black Swan, The Impact of the Highly Improbable

The US dollar trade weighted index tumbled anew to a multiyear low down .57% over the week to 80.12. This signifies a continuation of the US dollar’s softening against MOST global currencies, including our domestic currency, the Philippine Peso which appreciated considerably to its 7 year high or to its 2000 level at Php 44.8 against the US Dollar.

This comes even as the foreign entities reported a record buying binge of US assets ($126.1 billion) last May, which was more than enough to cover its twin (current account, budget) deficits. Said differently, when positive news is insufficient to buttress sentiment from its present lethargic trend, this could possibly denote of more turbulence ahead for the US dollar.

Figure 1: stockcharts.com: Gold and Carry Trade Currencies

As observed last week, even currencies that served to fund the du jour cross border asset arbitrages or the well known CARRY trades have seen a reversal as shown in Figure 1.

The Swiss franc at the lower panel has recoiled from its recent lows and appears to be testing its key resistance levels (red circle).

Meanwhile, the Japanese Yen at the upper panel; seems likewise to be in a rebound phase (blue circle). The Yen jumped .74% this week to 82.53.

Two issues to consider with the Japanese Yen. First technically, the Yen’s price action seems to be shaping out a looming trend reversal. The red channel lines above indicate of a falling wedge reversal pattern. A break above the upper trend line or nearly around 84.5 could possibly pave way for a massive rally in the Yen.

Second is that the Yen’s role in the “carry trade” has been an important feature in today’s levitated and highly leveraged markets.

The infirm yen had been partially prompted by Japanese retail investors seeking higher returns overseas by reducing their “home bias” and investing in Uridashi bonds or “foreign bond denominated in non-Yen currency issued in the Japanese market by a non-Japanese issuer” (Deutsche Bank Private Wealth Management).

Another is that the present “stable or low volatile conditions” have provided incentives for institutions to capture higher returns by taking on more leverage to arbitrage in the spreads of currency yield curves. In figure 2 courtesy of the IMF, institutions have been shown to take short positions on the Japanese Yen and the Swiss franc while profiting from the yield differentials of the Australian Dollar, Mexican Peso and the Brazilian Real.

Figure 2: IMF: Global Stability Report: Institutional Currency Positioning (percentile rank)

According to the latest Global Financial Stability Report issued by the IMF last April, ``One measure of the shift toward carry trade shows that institutional investors (so-called “real money”) have positioned themselves strongly in favor of carry trades over the past six months—funding in Japanese yen and Swiss francs and investing in high-yielding assets in other currencies—to an extreme percentile position (assessed over 1994–2007).

Mr. Bob Lenzner columnist for the Croesus Chronicles at Forbes.com cited Merrill Lynch estimates of about US$ 1 trillion worth of yen carry transactions.

To put in a wider perspective, given the global bond ($58 trillion 2005-McKinsey Quarterly) and equity markets ($50 trillion 2006-World Federation of Exchanges), such exposure would represent a rather small share to present itself as a major risk factor to the world capital markets.

However, drastic moves could spark a financial market turmoil in a particular market that could ripple across other asset classes as in the previous cases of May 2006 and the latest February 2007 “Shanghai Surprise”.

Back to Figure 1, the blue arrows in the upper chart depicts of the previous 2 instances of the Yen spikes. On the other hand, the EEM or the iShares Emerging Market Index in the lower pane above the center window, represented by the red arrows indicates of the coincidental downward volatility-possibly in response to the abrupt closing of several Yen carry positions.

Mr. David Kotok of Cumberland Advisors estimates the mark down as a result of a surging yen to world bond and equities market in 2006 at around $7 trillion and for this February, the losses were assessed at around $ 2 trillion.

Mr. Kotok qualifies the diminishing impact of the Yen’s upside spike as a “step function” where the financial markets gradually adopts with the expectations for its eventuality. In Mr. Kotok’s words, ``The step function is geometric and not arithmetic. The impact lessens each time an event occurs.”

Going against the tide in Asia, Japan’s yen has been the only currency experiencing losses amidst its massive trade surpluses. The Yen is down about 1.8% year-to-date. Yet, one must remember that Japan holds the second largest foreign exchange surplus, but paradoxically corollary to its monetary policy, again due to government intervention, depressed interest rates have spawned factors leading to resident based outflows and institutional yield arbitrages that has distorted its currency value levels, making it the world’s most “undervalued currency” according to the Economist.

In other words, while the global financial markets may be anticipating for an eventual rebound in the Japanese Yen to reflect on its fair market value, and thus a rise in yen may result to a much diminished impact, this does not eliminate the risks where an unheralded upside explosion by the Yen may trigger some upheavals in the marketplace.

And since the Yen carry has financed many of the present leveraged positions elsewhere, a Yen ‘shock’ could amplify adverse reactions in the other asset classes experiencing distress, such as the mortgage markets in the US and could become a contagion.

So as the US dollar presumably proceeds with its downside ordeal, it would be worthwhile to keep an eye on the movements of the Yen and consequently how the other markets react to it.

It’s always better to be safe than sorry.