One of the reasons that leveraged carry trade positions explode is a rally in the underlying currency which has financed the trade. In this case, it is the Japanese Yen which has been the funding currency. Those who put on this sort of trade are effectively short the Yen because when they exit the trade, they have to close out the positions that they financed and then buy Yen to pay back the original loan in Yen terms. As the funding currency rallies, they begin losing money because they are forced to pay a higher price for the Yen when they do the foreign currency exchange.
When we saw the Yen begin rallying sharply this past week it set off a cascade of unwinding of the carry trade as hedge funds dumped both stocks and commodities that had been purchased and then leveraged up as risk trades were quickly going underwater.
It now appears that the Bank of Japan has secured the cooperation of the entire G7 in knocking down the Yen which most agree had soared to levels that were nowhere near commensurate with an accurate valuation of the currency given the fiscal condition of the nation.
If it now appears that the G7 agrees to keep the Yen at bay then it could well be that the same hedge funds that were blowing out of their carry trades will be eager to reinstate them since they will feel that they have an effective upside cap on the Yen thus eliminating an element of risk in the trade.
If the nuclear plant situation in Japan can indeed get stabilized, that, combined with the cap on the Yen, could be the signal for the hedgies to pile back into the carry trade. It would not surprise me to learn that the BOJ would actually welcome such an event because it would keep a lid on the Yen and would thus serve their purposes of preventing the Yen from strengthening.
I would therefore view this as setting in place the factors necessary for keeping gold and silver well supported in price again. We will see how the market is interpreting these events in the trading that takes place over the next few trading sessions.
thanks for your good work Dan
ReplyDeleteHi Dan,
ReplyDeleteWhat effect do you think this (continued intervention and yen weakness) will have on other commodity currencies such as the AUD, CAD and particularly the NZD?
Great commentary. Thank you!
ReplyDeleteI wonder what China has to say about this.
ReplyDeleteChina benefits by the G7 action because its peg to USD means that the yuan stays cheap relative to yen.
ReplyDeleteIn fact China is the big winner this past week. It is no doubt licking its chops at all the spoils it will be picking up. Do the authorities relly believe that most companies, when they rebuild, will actually rebuild in Japan?
Nice...a little more moral hazard abatement for the hedgies/banks/etc. by the taxpayers of the world. Just silly.
ReplyDelete