Market Directions

Three terms have resurfaced in the currency markets recently, carry trade, risk aversion and risk appetite. The euro/yen cross is once again popular. Have world economic and financial conditions so improved that this risk barometer is again an active trade?
Yen Cross Basics

Three terms have resurfaced in the currency markets recently, carry trade, risk aversion and risk appetite. The euro/yen cross is once again popular. Have world economic and financial conditions so improved that this risk barometer is again an active trade?

A little more than a year ago, in June 2007, the American dollar was worth 124.00 yen. That month it began falling against the Japanese currency and by late March of this year it had landed at 96.00 yen –an astonishing 23% slide in ten months. Over a slightly later period, August 2007 to July this year, the dollar fell a comparable amount against the euro, dropping 20% in value from 1.3350 to 1.6037. But since then the yen and the euro have parted ways against the dollar.

On Friday the dollar closed at 107.90 against the yen, a 43% recovery of the 124.00 – 96.00 decline. But against the united currency the dollar finished the week at 1.5700, a bare 13% recovery of its 1.3350 – 1.6037 decline. The difference is the euro/yen. This cross has erased the entire credit crisis inspired collapse when it sank from just over 169.10 to 149.26 in two months. On the 17th of this month it reached a new all time high at 169.96. The dollar has hardly improved versus the euro but it has surged against the yen. Is the euro/yen the biggest factor in the dollar’s return against the yen? The euro/dollar rate gets most of the media focus but for currency traders the cross has been where the action is.

But that brings us to another question. The precipitate decline of the US currency over the past year has most often been portrayed as a US problem. Dollar weakness is the result of the interlocking housing and credit crises in the United States, their effect on the US economy and the Federal Reserve rate response. But is more happening? How can we disentangle the strands?

The dollar has benefited from euro/yen strength. But so has the euro. Both are supported when the cross rises because the euro/yen is calculated by multiplying the two individual dollar rates. Euro/usd multiplied by usd/yen produces the euro/yen cross rate.

The primary Japanese factor in the movement of the dollar yen, as the pair is called in the interbank market, has been the static nature of the Japanese economy and Japanese interest rates. For almost six years prior to mid-2006 the Bank of Japan had a zero rate policy. When the Bank of Japan finally raised rates to 0.25% in July 2006, the bank governors envisioned a slow return to a normal rate environment. But the persistence of deflation until last August, and the fear of the prior deflationary decade inhibited the BOJ’s ability to increase rates.

The bank last raised the overnight call rate by 25 basis points to 0.5% in February 2007. Since then it has been almost a year an a half with no credible threat of a rate increase. The BOJ may desire higher rates but the difficult state of the world’s financial system and the potential for a serious slowdown in the United States have prevented a hike. Even though the inflation rate in June was 1.9% annualized there is little expectation for a BOJ hike. Real interest rates in Japan are negative. For a borrower, that is a large enticement.

The Fed Funds rate in the US has been cut 325 basis points since last September. It is now 2.0%. The European Central Bank (ECB) last raised it base rate 25 basis points to 5.25%. For a trader, the enticement is irresistible.

The carry trade is said to consist of borrowing yen in Japan at low cost to invest in Europe (or New Zealand or Australia) at high return. As long as the yen does not climb in value against the deposit country currency the rate differential is guaranteed.

It doesn’t really matter if the yen is borrowed from a bank in Japan and then sold or if it is simply a long euro/yen position opened for speculative reasons; the result in the currency market is the same. The holder of the position earns the rate advantage on the overnight roll and takes the risk on the currency movement.

A long euro/yen position earning the differential between the euro and yen base rates results in the euro being forced higher and the yen lower. A long euro/yen position buys euro and a sells yen. Every holder of a long euro/yen position, from the largest hedge fund to the smallest retail trader, puts euro purchases and yen sales into the currency market. However that is not the end of the story.

All currency trades are paired. The euro and the yen are traded against the dollar as well as each other. A portion of any euro/yen deal may be converted into its dollar/yen and euro/dollar components. This procedure is called legging out of a cross trade, transferring the original cross position into its components or legs.

A euro/yen purchase when so converted ends up in a dollar sale versus the euro and a dollar buy against the yen. The end product of a euro/yen purchase can be a stronger euro and a stronger dollar (against the yen). If the dollar overall is weak it is possible for all the adjustment to be on the euro side, that is the euro dollar rises much more than the dollar yen to keep up with the higher euro/yen rate. But most of the time the euro/yen rate is absorbed across both the dollar yen and the euro dollar.

When the yen crosses fall the reason usually given is that the carry trade is risk averse. When the crosses rise traders are said to have regained their risk appetite. What exactly does risk mean in relation to the yen crosses? To the euro yen position holder risk aversion means that the advantage garnered by holding euro against yen over time from the interest rate edge can quickly and easily be swamped by movement in the value of the cross itself.

Take an unsophisticated example. The difference between euro and yen base rate is 4.75%. With no other charge (in reality all institutions charge for an overnight position) a move of 4.75% in a year in the value of the cross would negate the earned rate advantage. In just two months last year the euro yen lost 12%. This year it regained the same amount. Both moves had substantial impact on the trading rates of their component currencies, the euro dollar and the dollar yen.

The yen crosses can and do affect the trading rates of their components, the euro and the dollar, in ways which do not relate to the economic currents between the Eurozone and the United States.