It never does, and believe me I know after covering the biggest one ever from 2005-2008 while stationed in Tokyo (see PRDCs). Yes, bouts of volatility will spark carry trade unwinds. Some unwinds are bigger than others, with 2008 being the mother of all carry trade unwinds. But the simple fact is that using cheap funds to buy other stuff – even just higher-yielding currencies – is a bonafide strategy that works well over time, and only except in the most extreme cases of volatility. Of course there are risks, as with any strategy, and you would want good warning signals on when to unwind to beat the crowd rushing for the exits at the same time.
Still, this yen carry trade is likely just in the beginning stages. Our BOJ sources have said they are worried about a suddenly weak yen at a time when Japan is needing to import even more energy and stuff for reconstruction. Let’s see. At the end of the day, the BOJ is underwriting another carry trade. So is the Fed. The ECB’s rate hike – whatever you think about hiking rates while the third euro zone member in the past year is getting a sovereign debt bailout – has underscored how the Fed is going to lag, and that means the dollar remains a carry funding currency.
It was a brutal and at times scary week. There are plenty of unknowns around the radiation risks tied to the Fukushima nuclear plant. But the fact remains that this nuclear crisis after the quake/tsunami shock may not deal the economy too severe a blow. If nothing else, the shock is prompting a policy response that was always lacking in Japan before: hefty fiscal spending is on the way, and the Bank of Japan has injected money into the system like never before, and via all kinds of channels. The BOJ’s response has helped to quickly stabilise funding markets and asset markets as a whole. The G7 is backing up Japan on yen intervention. Foreign institutional investors were cited in the last few days as steady buyers of Japanese equities, seeing this as an opportunity as the price-to-book on the TOPIX once again fell to a meagre 1.0 (for comparison, it is in the company of Serbia, UAE, Lebanon, Italy, Greece and Venezuela – so yes maybe cheap). From a markets point of view – a minor one in this crisis – Japan did an admirable job shoring up the markets after their were gripped by panic. Keep in mind that sharp policy responses to panics linger for a while, usually well into any recovery. Just as the Fed launched QE2 the moment the U.S. economy was picking up a head of steam, Japan may be countering an economic shock that may not be as big as feared. If so, it could be just the jolt the Japanese economy has long needed just as it was gathering momentum. All that said, the radiation risks, factory shutdowns and threat of power outages will add to the doubts about how quickly the economy will bounce back in the next few months.
JGB risks: The chart below says a lot. Over time, gradually, investors are seeing greater risks in JGBs. Not just those supposed speculators in CDS, but even in the mostly domestic market where the yield curve has stayed historically steep for a while now. The risks are now even greater. Does the need for greater borrowing push JGBs closer to a tipping point? The BOJ may step in to help fund some of the reconstruction costs, but it has showed a great reluctance to be seen underwriting the government. Whatever the BOJ does, the JGB outlook is one that keeps slowly deteriorating. Near-term risks include insurer selling and the lack of buyers heading into fiscal year-end. Beyond fiscal-year end is the big question. A lot of liquidity is in the banking system, and households may start boosting savings again. But the risks are building.