A carry trade is when an investor borrows a currency with low interest rates, such as the yen, and uses it to buy assets in another currency with a higher interest rate, such as the Australian dollar.
The yen carry trade had fallen out of favor with traders after the "Lehman Shock" of 2008 as governments attempted to deal with the financial crisis by cutting short-term interest rates and initiating successive rounds of quantitative easing.
In the post-Lehman world, global interest rates converging on zero and massive balance sheet expansion by central banks to combat sluggish economies and deflation have become the norm. As a result, the yield spread between the currencies being borrowed and the currencies being used to purchase higher-yielding assets has fallen, making the trade riskier and less attractive.
Now that the new Abe government in Japan has succeeded in talking the yen down to two-and-a-half year lows and seems to be looking to push the yen even lower, traders are once again using short-term yen borrowings to fund short-term purchases of assets in other, high-yielding currencies such as the Norwegian krone or the perpetual favorite, the Australian dollar.
"Using the lowest yielder, the yen, to fund purchases of the Australian dollar could generate a 3% annual yield spread, without leverage and before the expenses of any investment fund used to put on the trade," writes Hamlin Lovell in the CFA Institute's Inside Investing publication.
And David Harden, senior commercial dealer at Global Reach Partners, told CNBC Europe, "Not only is the yen losing ground because of Abe's comments and monetary policy. But also, we're seeing risk appetite improving across the globe and so the yen is weakening because it was a safe-haven currency and now it's being sold because people are buying risk again."
Dangers of Reaching for Yield
Of course, the real question is: How much risk are traders willing to take on?
The monthly volatility of the Australian dollar/yen cross is 4.91%. Is it really worth risking 4.91% a month in order to gain 3.0% a year in excess yield?
It is only if you think the Australian dollar is going to continue to strengthen against the yen. In that case, an investor would make a lot more money from the appreciation of the Australian dollar against the yen than would be made from the higher yield paid by Australian dollar assets.
The problem with carry trades is that they tend to get very popular among the banks and hedge funds that trade them. History shows that these trades tend to move in only one direction as everybody jumps aboard the bandwagon.
This makes the yen carry trade extremely dangerous because interest rates in the three largest economies in the world - the U.S., Europe and Japan (China is excluded because its currency does not trade freely) - are all converging on zero.
Everyone is looking for a few extra basis points. Everyone is taking a lot of extra risk for the small extra returns they can get.
And it will all be OK until, one day, it isn't. That's what makes this latest iteration of the yen carry trade so dangerous.
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