By Graham Summers
Read anything from the financial press for more than two pages and you're bound to see "carry trade" mania...
A carry trade is when you borrow money at a low level of interest, then use that money to buy securities yielding a higher rate of interest. Currently, the most commonly referenced carry trade involves the yen and the dollar. This carry trade has been popular among international investors twice before – once in the late '80s, and again in the mid '90s – but for brevity's sake, we'll address the most recent carry trade, which began in March 2001.
Having suffered an economic recession for much of the previous two decades, Japan attempted to fuel economic growth by lowering short-term interest rates almost to 0% (0.069% to be exact) in March 2001. At this rate, you could borrow $100,000 and pay $69 annually in interest.
Investors worldwide took advantage of this to borrow massive amounts of capital in yen. They then converted this capital to dollars and bought T-bills that were yielding between 4% and 5%.
It was a pretty sweet deal that got even sweeter when you leveraged your trade. Consider the following example...
Let's say back in March 2001, I had $10,000 in cash. I then borrowed $90,000 worth of yen from the Bank of Japan. After converting this money to dollars, I had $100,000 in capital, which I put into Treasury bills yielding 4%.
Over the next year, I made $4,000 in interest on my T-bills (4% of $100,000). I then sold my T-bills, converted the $90,000 I borrowed back into yen, and paid back my loan to the Bank of Japan (plus a tiny amount of interest). I kept the $4,000 for myself.
Now based on T-bill interest rates, I should have only made 4%. However, because I was using leverage (borrowed money), I actually made 40% ($4,000 on my original $10,000). So as long as the yen stays low compared to the dollar, I can make a killing.
This is precisely what some institutional investors and hedge fund managers have made a fortune doing for the past five years. They were essentially selling short the yen and going long other, higher-returning securities. This move continued to push the yen down.
However, the Bank of Japan started raising interest rates last July. Today, the short-term lending rate is 1.25%. And the yen has begun to rally. Between this and the hiccups in the market, investors have been returning funds to the Bank of Japan.
That's what triggered the news frenzy – which is way overblown.
The yen carry trade is now a buzz phrase with the talking heads. And it's become the scapegoat for any hiccup in the market. Everyday headlines ask, Will the carry trade last? What will happen to global liquidity?
It's true that the Bank of Japan has supplied the world with greater liquidity, but not nearly on the level most analysts would like you to believe.
The Japanese ministry of finance and the Bank of Japan believe that short-term, carry trade-related borrowings in the yen come to between $20 billion and $40 billion. That may sound like a ton of money... but it's not. It's about one-fifth of Wal-Mart's market cap.
Even when you add in individual Japanese investors, the total amount of money involved in the carry trade is believed to be around $170 billion. That's about one-tenth of the combined market cap of the S&P 500.
However, this $170 billion is spread out over various indexes, bonds, etc, throughout the entire world. It's just a drop in the sea of global liquidity. Consider that more than $65 trillion trades on the NYSE every day.
Make no mistake, if the yen continues to rise and the yen carry trade unravels, it will cause a shakeup in the marketplace. But don't believe the hype...
The yen carry trade has unraveled twice before, and the world didn't end. It won't this time either. And there are always going to be great investments out there for our money.