The yen carry trade

The latest source of anxiety for bond traders has some surprising currency linkages. The yen carry trade, wherein the cheap-to-borrow yen (created by Japan’s post-2002 program of “quantitative easing” of its money supply) are lent elsewhere in risky assets, may be coming to an end. (See “The yen stands alone,” Currency Trader, March 2006.) Carry essentially is the spread between the cost of borrowing and the returns on lending. Certainly the Bank of Japan has signaled this to be the case; Governor Toshihiko Fukui first indicated quantitative easing would end in December 2005 and then signaled Japan’s zero-percent short-term interest rates would end on Feb. 3, 2006.

Before we continue, let’s debunk the notion that the health of the bond market depends on high carry. The Federal Reserve has been raising the federal funds rate like clockwork since June 2004, and the 10-year note’s yield has barely budged. Long-term interest rates are set by the supply and demand for credit, by inflation expectations, and, as we shall see, by the volatility of the currency market. If the idea that long-term rates and the price of risky assets such as stocks were determined by carry was true, the yield curve would have a constant shape and stock prices would be discounted off the federal funds rate, not the long-term capital markets rate. Neither is true, but once again we are responding to irrational fears with facts — a losing trade.