Implications

Japan increased its short-term rates in February 2007 by 25 basis points. This
eroded the economics of the yen carry trade somewhat and created an incentive for all carry traders worldwide to rush for the exits at the first whiff of the next move. This is the classic “negative- sum” game, one wherein the players minimize the welfare of the group as a whole by attempting to maximize their individual welfare. Think of a crowd trying to leave a burning building, or of the short-lived global market panic at the end of February and beginning of March.

As we have seen above, it is the net interest rate spread, not the spot rate component, that drives the yen carry trade and its returns to both short-term interest rate (STIR) funds and to emerging market equity funds. These countries have benefited greatly from the yen carry trade as it brings badly needed funds into their economies and, if their equity markets are any indication, helps support their economies. The world got a brief taste in May- June 2006 and again in February- March 2007 of what can happen to emerging market equities when short term interest rates rise in Japan (Figure 7).

The first shock was managed and contained in relatively short order, and emerging markets regained their highs within six months; the second shock was even more short-lived. Emerging markets and others should not regard these quick rebounds as global applause for their policies or their high interest rates and depreciating spot currency rates, but rather as pullbacks by the Bank of Japan in its policy to raise short-term interest rates. The BOJ had to overcome internal political resistance to make its February 2007 rate hike, and it has eschewed the opportunity to
engage even in hawkish rhetoric.

They are acting as if a Bank of Japan put option, similar to the fabled Greenspan put option, is in place. The Greenspan put failed eventually, as the U.S. entered its worst bear market since the Great Depression in 2001. The same will happen eventually with the yen carry trade. Restated, anyone who thinks they found a perpetual motion machine in Tokyo had better think again.