I can’t remember how long it’s been since I was hyping the Yen carry trade (though a browsing of the ForexBlog archives indicates 2 years). Upon the outset of the credit crisis, forex markets went haywire, and one of the main “beneficiaries” was the Yen, which soared as carry trades were unwound. Now, however, a similar set of circumstances that made the Yen carry trade attractive from 2006-2008 have re-appeared, and it looks like the trade could be on the verge of making a big comeback.

Practitioners of the carry trade understand that it has a few pre-conditions. The first is low interest rates. In this case, the benchmark Japanese interest rate is only .1%. While that would have meant something a few years ago, however, it no longer counts for much, since benchmark rates in other industrialized countries are just as low. Where Japan has the edge is in market interest rates. Long-term rates have historically been well below the global average, and short-term rates are finally following suit after a 3-year hiatus. In fact, for the first time since August, the 3-month Japanese LIBOR rate – a lending benchmark – fell below its US counterpart: “On Thursday, the yen Libor JPY3MFSR= was fixed at 0.25063 percent — its lowest level since May 2006 — and the dollar USD3MFSR= rate at 0.25219 percent.” In short, the Japanese Yen is once again the cheapest currency in the world to borrow.

In addition, interest rates in Japan will probably remain low for the immediate future, as the Bank of Japan is actually looking to make its monetary policy even more accommodative (I didn’t think this was possible with a benchmark rate of only .1%!), in order to further stimulate the economy and alleviate the risk of deflation. This contrasts with Central Banks in other countries, which are already contemplating interest rate hikes.

The second condition is low volatility. ” ‘Realized trading vols has not been so low for many years.’ For example, three-month implied vols in the euro have slipped from a 25-plus high at the peak of the subprime crisis to levels around 10.68 currently…’As volatility goes down,’ the FX market tends to move toward a ‘classic carry trade environment.’ ” Low volatility is important because it enables investors to make low-risk bets on interest rate differentials without worrying too much about currency fluctuation. However, it doesn’t hurt that aversion to risk is also trending lower, such that investors can borrow in Yen to make higher-risk bets. According to the <a href=”http://www.businessweek.com/news/2010-02-28/carry-trades-may-play-larger-role-in-currency-markets-bis-says.html”>Bank of International Settlements, “The carry-to-risk ratios, a measure of the appeal of carry trades, have ‘been steadily rising over the past 14 years, consistent with an increasing attractiveness of the yen-funded carry trades for Australia and New Zealand.’ ”

The pickup in risk aversion – as a result of the Greek debt crisis – may have delayed the return of the Yen carry trade. In January, volatility rose slightly and the Yen rallied as the safe-haven mentality set in. Personally, I find this somewhat ironic, since Japan’s debt problems are even more pronounced, and unlike Greece, it can’t count on a bailout from Greece if things really get rough. Still, the markets work in strange ways, and the fact that the Yen has benefited from the crisis is probably due to the fact that traders can’t short all currencies simultaneously.

The third condition is really an outgrowth of the first two: belief that the funding currency will remain stable, or even decline. In this regard, the Yen is still hovering near an all-time high against the US Dollar, and given the confluence of bearish economic and political factors, it would seem to ne headed downward irrespective of the carry trade. For those looking for specific reasons to short the Yen, there are plenty from which to choose: low economic growth, dismal performance in finance markets, high public debt, dwindling savings and an upcoming retirement boom. As one analyst argued, “Tokyo is due to announce its medium-term fiscal plans in June. ‘Either this will mark the start of a prolonged period of fiscal restraint, weakening the economy again and requiring further monetary loosening, or the plans will lack credibility, in which case Japan’s financial markets would be hit hard. In either scenario, the yen looks vulnerable.’ ”

I don’t mean to get excited, but it’s hard to state a better case in favor of an imminent return of the Yen carry trade.

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A report into the collapse of US bank Lehman Brothers criticises senior executives and auditor Ernst & Young for serious lapses.

I know the idea of day trading really scares a lot of people, especially newbies to trading. You don’t want to fall for the same traps that so many others fall into. But it is nevertheless very enticing.

One of the pitfalls of forex blogging (or all financial reporting for that matter) is that it’s inherently after-the fact. In other words, any information about the past – while relevant – is inherently useless, since it has theoretically already been priced into the asset (or currency in this case). Before I begin my post on the Pound’s recent decline and the factors that wrought it, then, I wanted to offer the caveat that in analyzing past events, we must simultaneously look to the future.

Anyway, for anyone watching the Pound Sterling over the last month, its performance has been startling. It is down 7.5% for the year already (we’re only in March!), and has fallen 12% from its August peak of 1.70 USD/GBP. This represents an unbelievable about-face, as the Pound spent much of 2009 floating upwards following its lows from the credit crisis.

What’s behind the decline? In short, economics and politics, or more precisely, the junction of economics and politics. As the British economy began its recovery from recession, analysts began to turn their attention to UK government finances. Another way of looking at this would be to say that analysts have shifted their gaze from the positive effect of government intervention (i.e. economic recovery) to the many lasting negative effects. Inflation and government solvency, of course, are the two most pernicious of the bunch.

The Bank of England’s quantitative easing program was comparable to the Fed’s program in relative terms, and in the aftermath of all of that money creation, inflation is slowly creeping up. The government’s free spending also contributed, and now, so is the sinking Pound, as prices for commodities and other imports are rising fast in local currency terms. Speaking of government spending, the UK government budget deficit is projected at 12% for 2010, slightly higher than 2009. You can see from the chart below that budget deficits are forecast to remain large for the next few years. Expectations are so low, in fact, that a reduction in the deficit to 3% of GDP by 2014-2015 would be viewed as a victory.

Naturally, the UK government feels some pressure to reduce its deficit, both for the sake of financial solvency and to control inflation. The problem is that an election must be called before June, and until then, there is natural pressure to continue operating the money printing presses 24/7 in order to appease the voting public. The same goes for the Bank of England; it can’t be expected to tighten monetary policy and/or reverse quantitative easing until after the election.

I’m not going to pretend that I understand British politics, but from what I’m hearing, it seems the problem is that the election polls are now very close. Previously, a major victory by the Conservative Party was seen as inevitable, and this was viewed positively by financial markets because of the expectation that they would rein in spending. Recently, the incumbent Labour Party has closed the gap, to the extent that a hung Parliament is now a likely outcome. This would be even less desirable than an outright Labour victory, because the sharing of power would make it unlikely that reforms of any kind would be enacted. With regard to forex, some have posited an inverse correlation between the rising popularity of Labour and the falling Pound.

With the crisis in Greece still unresolved, analysts are also making comparisons to the UK. Some have suggested that if Greece were to receive a bailout, then, investors would turn their attention to the UK, whose finances are in equally bad shape. Without the protection of the Euro, the Pound would be open to speculative attack. On the other hand, that the (declining) Pound is independent from the Euro could become in advantage, if it boosts exports.

Going forward, it’s difficult to make any predictions until after the elections and/or the government makes a firm commitment to reduce spending and lower its deficit. Some analysts think that regardless, the Pound is doomed to continue falling, perhaps all the way to the .40 mark. Others see the current decline as the “darkness before the dawn.” As I noted in the introduction to this post, the latter could certainly be right. Besides, most of the uncertainty has probably already priced in. While most of the factors currently weighing on the Pound are bearish, some contrarian investors might see this as a good opportunity to buy. And who’s to say they’re wrong?

Public and transport services grind to a halt in Greece as workers stage a third strike in protest at austerity measures.

Public and transport services grind to a halt in Greece as workers stage a third strike in protest at austerity measures.

Public and transport services grind to a halt in Greece as workers stage a third strike in protest at austerity measures.

Public and transport services grind to a halt in Greece as workers stage a third strike in protest at austerity measures.

Public and transport services grind to a halt in Greece as workers stage a third strike in protest at austerity measures.

Public and transport services grind to a halt in Greece as workers stage a third strike in protest at austerity measures.