Year after year, professional analysts at banks and brokers forecast the dollar will fall against the Euro because of the disastrous twin current account and budget deficits. Ho hum. Year after year, the dollar may fall on a net year-over-year basis, but not (so far) by disastrous amounts. In 2006, the dollar fell 11 percent vs. the euro, but this is not panic selling. In fact, the dollar has been a net gainer against the other major currency, the Japanese yen (only 1.5 percent but a gain is not a loss).
The reason for the dollar’s firmness against the yen is the much-referenced carry trade. Hedge funds and others borrow yen at 0.50 percent and invest it in other currencies at rates ranging from 3.5 percent to 7.5 percent and keep the difference. A net differential of 3 percent to 7 percent sounds like a small amount, but double or triple that because of the effect of leverage, and suddenly you’re looking at some interesting amounts of money.
Meanwhile, Japanese investors are also placing their funds abroad. Even ordinary citizens can place funds in foreign- currency denominated accounts offered by banks and brokers, many of them with built-in exchange rate hedges. Because Japan is just coming out of a near-decade of deflation — and will probably dip back into deflation this year — nobody expects the country to have competitive interest rates any time soon. Therefore, the carry-trade gravy train could go on indefinitely and other countries with higher interest rates (including the U.S.) can count on capital inflows indefinitely, too.
What upsets this apple cart, of course, is a rise in the yen that would make those yen loans overly expensive to pay back. Every carry trader knows his own breakeven exchange rate, which is a function of the leverage being used and the net differential being earned, and nobody knows the collective breakeven exchange rate.
Lets say that the early-bird carry traders started at the beginning of the yen down move in January 2005 when the dollar/yen (USD/JPY) was at 103.00, used leverage of two times, and got a net differential of 5 percent. Excluding reinvested gains, the yen can rise 10 percent from the starting point to 92.70 before that carry-trader needs to exit.
That’s the extreme best-case scenario; in practice, many carry traders probably got in at the median price of 117.00. So, with the same assumption of a 10-percent breakeven, they need to start worrying when the yen gets around 105.00. That’s a long way away — the yen is currently above 120.00 — and you’d have to be comatose not to notice a 15-yen move. Naturally, no investor would wait until the last minute. Carry traders believe in trends as much as the rest of us, so any hard evidence of a yen uptrend would trigger exits well ahead of the true breakeven levels, fueling any movement and turning it into a true trend.
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