The Yen Carry Trade Is Back

04/04/2011 9:29 am EST

Focus: GLOBAL

Eoin Treacy

Global Strategist, Fullermoney.com

Concerted selling of the Japanese currency by allied governments has revived the hunt for global yields, writes Eoin Treacy of Fullermoney.

The yen carry trade was the funding conduit of choice for leveraged traders prior to the financial crisis.

For it to be profitable, traders needed to be able to borrow yen at a low rate and reinvest that capital in a higher yielding or better performing asset. Right now, Japanese and US interest rates remain close to zero.

The advent of multilateral intervention has increased the supply of the Japanese yen (FXY)—so the currency's nascent downtrend could be described as state-sponsored. There are a host of potential avenues in which to invest on a leveraged basis.

[Including a leveraged short-yen fund (YCS) that some are hoping will double or even quintuple in the long run—Editor.]

The Asian Dollar Index, where the Korean won and Singapore dollar are two of the stronger currencies, has been consolidating in the region of the 2008 peak for the last few months. It recently broke upwards to new recovery highs, and a sustained move below 115 would be required to question potential for additional upside.

The Latin American Dollar Index, which is heavily weighed by the Brazilian real (BZF) and Mexican peso (FXM), also hit a new recovery high today. A sustained move below 113 would be required to question medium-term upside potential.

Countries with comparatively high interest rates, especially those more likely to increase them over the short to medium term, are particularly alluring for "born again" carry traders.

South Africa
The South African Repo rate appears to have bottomed at 5.5%, offering an attractive carry for those with a short position in the currency. The South African rand (SZR) is currently rallying towards the upper side of a two-year range against the yen, and a clear downward dynamic would be required to check potential for additional upside.

The rand-denominated ten-year yield remains within a five-year range and is currently near the upper side, close to 9%. While this area has offered resistance on a number of previous occasions, a break in the short-term progression of higher reaction lows would be required to indicate another rejection.

Brazil
The Brazilian Selic target rate has risen from 8.75% early last year to 11.75% at present. The real found support near the lower side of an 18-month range a few weeks ago and is currently rallying towards the upper side.

The relatively liquid real-denominated three-year bond yield is currently testing the upper side of an 18-month range, and a sustained move below 12.75% would be required to question potential for some additional upside.

Russia
The Russian refinancing rate is currently at 8%. The Russian ruble (XRU) found support against the yen from late October and has trended steadily higher since. It is now testing the ¥3 area, but a clear downward dynamic would be required to check potential for some additional upside.

The ruble-denominated Russian zero-coupon ten-year bond hit a medium-term peak near 8.5% in February and is currently testing the lower side of a three-month range. An upward dynamic will be required to indicate a return of demand dominance in this area.

Next: Indonesia and Australia

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Indonesia
The Indonesian reference rate is currently at 6.75%, but is likely to rise further over the medium term. The rupiah, in common with a number of the above cross rates, is rallying from the lower side of a two-year range.

The rupiah-denominated ten-year bond yield hit a near-term peak close to 9% in January, then returned to the first area of potential support near 8%. It will need to rally from the current area to demonstrate supply dominance in this area.

Australia
The Australian target rate of 4.75% has been on hold since November. Additional interest hikes may be delayed due to the cost of rebuilding following the Queensland floods.

However, the Australian dollar (FXA) has surged against the yen over the last few weeks, not least because it is liquid, easily traded and has a favorable interest-rate differential.

The Australian ten-year yield has been ranging below 6% since mid 2009. It found support near 5.25% a few weeks ago and is currently rallying towards the upper side of the range. A sustained move below 5.25% would be required to indicate a change of trend

The above currencies all look primed to advance versus the yen over the short to medium term. Most of the respective bond yields have not attracted significant bullish interest. This may be because the potential for additional interest rate hikes, aimed at combating inflationary pressures, currently outweighs the allure of the carry trade.

On the other hand, the stock markets for these countries have all bounced emphatically of late, and would need to sustain moves below their respective 200-day moving averages to question medium-term upside potential.

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