Yen Unbeatable as Credit Seizure Proves `Carry Trade Is Dead'

By Ye Xie

Oct. 6 (Bloomberg) -- The same credit market collapse that drove Lehman Brothers Holdings Inc. into bankruptcy and sent bank borrowing costs in Europe to record highs is making the yen unbeatable.

Japan's currency was the best-performer in September and the only currency to appreciate against the dollar. Deutsche Bank AG, the biggest trader of foreign exchange, says the yen will rise 5 percent in coming months. New York-based Morgan Stanley is telling clients to buy the currency versus the euro and pound.

After seven years of providing the cheapest source of funds for investors buying higher-yielding New Zealand dollars, Australian dollars and Brazil reais, the yen is appreciating as $587 billion of subprime mortgage-related losses force banks to restrict credit. It strengthened 4.4 percent on a trade weighted basis in September, according to the Bank of Japan's effective exchange rate, the most since August 2007, when the seizure in capital markets began.

``We are in a multi-year trend reversal,'' said Paresh Upadhyaya, a senior vice president at Putnam Investment LLC in Boston who helps manage $50 billion in currency assets. ``We are going to see a global central bank easing cycle. The yen is the place to be in this environment of economic slowdown and heightened volatility.''

This year will be the first since 2002 that the economies of the U.S., euro-region and Japan all expand less than 2 percent, according to data compiled by Bloomberg. The BOJ's effective exchange rate rose 5 percent from April through September of that year, the best six-month performance since the end of 1999.

`Counter-Cyclical Currency'

Strategists are turning more bullish, forecasting the yen will end the year at 107 to the dollar, compared with an expectation of 109.15 on Sept. 12, according to the median of 40 estimates compiled by Bloomberg.

``The yen is a counter-cyclical currency,'' said Richard Benson, who oversees $14 billion of currency funds at Millennium Asset Management in London. ``When the global economy looks bad, the yen should do well.''

The currency lost 60 percent against the Australian and New Zealand dollars in the seven years ended June 30, and depreciated 24 percent versus the real and 20 percent to the British pound. The main cause was the so-called carry trade, where investors took out loans in Japan to take advantage of the lowest benchmark interest rates among the Group of 10 industrialized nations. They then sold the yen and invested the proceeds in high-yielding assets outside the country.

211 Percent Return

Investors who used the strategy to buy the New Zealand and Australian dollars, euro and pound, would have generated a return of 211 percent on average in the past seven years, according to data compiled by Bloomberg. The trades would have lost 13 percent this year.

The collapse of Lehman, the government takeovers of Fannie Mae, Freddie Mac, American International Group Inc. and Washington Mutual Inc. and the forced sales of Merrill Lynch & Co. and Wachovia Corp. reduced confidence in the world's financial system.

That in turn has made banks wary of lending to each other, pushing the three-month London interbank offered rate in dollars to 4.33 percent from 2.81 percent on Sept. 15, the day New York- based Lehman filed for bankruptcy protection, according to the British Bankers' Association in London. The increase in rates and drop in credit is forcing speculators to close out carry trades and pay back yen-denominated loans. The currency's biggest gain the past month has come against the real, rising 20 percent.

Lower Rates

The slowing world economy is also helping the yen by boosting expectations that central banks will lower borrowing costs. Policy makers in Europe, Australia, New Zealand and Brazil will cut interest rates next year, according to the median estimates of economists surveyed by Bloomberg.

Futures on the Chicago Board of Trade showed an 84 percent probability yesterday the U.S. Federal Reserve will lower its 2 percent target rate for overnight lending between banks by a half-percentage point at its Oct. 29 meeting. Traders saw no chance of a cut a month earlier.

``The carry trade is dead,'' said Derek Halpenny, European head of global currency research at Bank of Tokyo-Mitsubishi in London. ``The world is deleveraging.''

The yen strengthened to 143.99 per euro on Oct. 3, the highest level since June 2006, before ending the week at 145.11. It gained 0.6 percent against the dollar to 105.32.

Hedge funds and speculators increased bets that the yen will appreciate versus the dollar to the highest level since July 18, data from the U.S. Commodity Futures Trading Commission show. Wagers on an advance in the yen outnumbered those on a drop by 43,022 on Sep. 30. As recently as Sept. 2 they were betting on a decline in the yen.

Turning Bullish

Morgan Stanley strategists turned bullish last week, saying in an Oct. 2 report to clients thy yen may strengthen to 135 per euro and to 165 per pound from 188.10. Frankfurt-based Deutsche Bank expects it to rally to 100 to the dollar. Bank of Tokyo- Mitsubishi UFJ Ltd, Japan's largest bank by market value, raised its forecast last week to 100 per dollar by March from 102. It predicts the yen will gain 11 percent versus the pound in a year.

Further gains may depend on whether U.S. Treasury Secretary Henry Paulson's $700 billion plan to revive credit markets by purchasing depreciated assets from banks boosts investor confidence.

The carry trade ``is a strategy that has a good track record,'' said Pablo Frei, a money manager at Quaesta Capital in Switzerland, which oversees $1.2 billion in currency funds. ``You have to unwind carry during times of high risk. There will be a day that it will be put on again. The question is when.''

`Structural Shift'

Quaesta Capital's currency funds have reduced the amount of money in carry trades to less than 5 percent of assets, from about 30 percent a year ago, Frei said.

Investors in Japan will continue to invest internationally to diversify their holdings as risk appetites return, capping the yen's strength, said Rebecca Patterson, global head of foreign exchange in New York for the private wealth management unit of JPMorgan Chase & Co.

Japanese mutual funds increased purchases of overseas assets to 36.89 trillion yen ($369 billion) by the end of last year, from 3.06 trillion yen in 2000, according to Japan's Investment Trust Association.

``What's happened in Japan in the last two, three years has been a structural shift of the Japanese mindset,'' said Patterson. ``They view these as long term investments. The yen negative flows will slow in times of trouble like this. But I don't see a lot of this is a longer-term shift.''

Rising Volatility

Carry trades became popular as swings in exchange rates fell to record lows because there was less risk that rapid changes would wipe out profits.

Now, that is changing. Implied volatility on major currencies rose to 16.69 percent on Sept. 17, the highest level since 1998, according to the JPMorgan G7 Volatility Index. The gauge of price swings touched 5.76 percent in June 2007, the lowest since the index's inception in 1992.

The percentage of currency reserves held in yen by foreign central banks increased for a third straight quarter through June, according to the International Monetary Fund.

Yen now accounts for 3.4 percent of global reserves, compared with 2.8 percent a year earlier, the lowest amount since at least 1999. The dollar is the world's largest reserve currency at 62.5 percent, IMF figures show. Morgan Stanley strategists said in their Oct. 2 report that the yen may overtake the pound, which is No. 3 at 4.7 percent, in ``coming quarters.''

``There are many risks in the United States and Europe,'' said Satoshi Okumoto, a general manager at Fukoku Mutual Life Insurance Co. in Tokyo, which has $54.1 billion in assets and is Japan's eighth-biggest life insurance company. ``Fund managers are starting to shift their money to yen. They are starting to overweight yen in terms of currency allocation.''

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net.