One of the strongest major currencies in the world since the onset of the 2008 crisis has been the Japanese yen. This is a dramatic change of fortune for what had long been — and what should be — a weak currency.
Click to Enlarge Take a look at this chart, which tracks the dollar/yen exchange rate. In late 2008, a dollar would buy you 110 yen. Today, a dollar will not buy you even 80. And remember, the dollar has been relatively strong over the past four years. The yen’s performance against the euro or British pound would be even more dramatic.
Anyone who follows Japan must legitimately be scratching their heads in confusion right about now. In a market in which investors have been shunning risk for the past four years, why would the currency of the most heavily indebted major country in the world rise? Japan’s sovereign debts stand at 220% of GDP, and the country has struggled to rein in its mammoth budget deficit. Japan has routinely had budget deficits in excess of 10% of GDP.
What’s more, investors are not really getting compensated for holding yen. Japanese short-term rates have been at or near zero for the better part of two decades, and even the 10-year bond yields a measly 1%.
Have currency traders lost their minds? Perhaps. But the yen’s rise is not so hard to explain when you consider a couple points. First, the yen was the primary funding currency for the assorted carry trades beloved by so many hedge funds. In a typical carry trade, a trader will borrow in a low-yielding currency like the yen and put the proceeds into a higher-yielding currency like Canadian or Aussie dollars or, until recently, the euro or pound.
The trader would make money in two ways. First, they earn an interest rate spread, the difference between their borrowing rate and their lending rate. This is how banks operate in the lending markets as well, borrowing cheaply and lending dearly. But there also is a secondary benefit. These activities of traders tend to create trending markets. Low-yielding currencies tend to trend downward, and high-yielding currencies tend to trend upward. So, in addition to the interest rate spread, traders also enjoy gains from a nice pair trade.
Or at least they used to. A couple things caused this trade to fall apart. First, when the capital markets ceased functioning during the 2008 meltdown, there was a rush by traders and investors of all stripes to deleverage. When the world as we knew it was ending, it didn’t make a lot of sense to owe a lot of money. Traders responded by closing out their carry trades, which caused the pair trade to operate in reverse. They scrambled to buy yen rather than sell them. It wasn’t exactly a short squeeze, but the results were much the same. Buying begets buying, and the former object of intense shorting shot to the upside in 2008 and early 2009, causing the yen to gain on all major world currencies.
So why, might you ask, did the yen not drift lower in the years that followed? Here, the answer is less clear, but a few reasons are likely.
First, the carry trade lost its appeal for a lot of burned traders, and many came to view it as picking up nickels in front of a steamroller; too much risk for too little return. And secondly, the attention of active currency traders shifted to Europe and its sovereign debt crisis, giving the yen some breathing room.