Financial markets have always been good at turning lemons into lemonade, but the popularity of one such move is leaving a sour taste for hedge funds across the globe.
When Japan's stock market and real estate bubble burst in the early 1990s, it kicked off a vicious wave of deflation that eventually pushed interest rates in that country to zero percent and has kept them well below those in the rest of the world, even during its incipient recovery.
Cue hedge funds, who have made a fortune borrowing in yen and plowing the cash into higher-yielding assets from Icelandic bonds to Australian real estate to U.S. collateralized debt obligations. This works great much of the time, but the popularity of the strategy has made periods of financial turbulence even more chaotic for investors.
"It's like the old saying about picking up nickels in front of a steamroller: It looks easy, but sooner or later you get crushed," said Chris Watling, president of London consulting group Longview Economics.
Currency volatility would seem to be an issue far-removed from U.S. equity prices, but a handful of stock market veterans like Art Cashin of UBS have long warned investors to "watch the yen," remembering the way in which it helped make the 1998 Russian debt default into a far more serious financial event.
Both in 2007 and 1998, currency-specific factors such as the U.S. current account deficit or relative interest rates had nothing to do with starting the crisis itself, but big borrowings in yen greatly worsened the damage.
"It's a tsunami, it's a force unto itself," said Quincy Krosby, chief investment strategist at Hartford Financial. "It helps to exacerbate the effects of a trend in the market when you have a huge unwind."
Estimates of the size of the yen carry trade vary from $130 billion to $450 billion, and even the Bank of Japan doesn't have a full grasp of the sums involved. The notional size of bets made with these borrowings could be much larger through use of derivatives.
Watling and Krosby point out that the rapid unwinding of borrowing in yen was just a symptom of excesses elsewhere in the system and not the proximate cause of recent volatility.
"This was a wave of risk aversion with a carry trade behind it, so it was a source of funds," said Watling. "There's always a source of funds."
But it's more complicated than that. Central banks that find their currency under selling pressure often have their hands tied in terms of avoiding even more painful steps, such as boosting rates. A currency that is too strong can be more easily remedied. Japanese authorities used to intervene massively, but they have been on the sidelines since 2004 as hedge funds were only too happy to sell yen for them as asset prices boomed.
"Essentially, the yen carry trade has done the job of intervening," said Krosby.
Now the question hanging over the market is if the Bank of Japan will intervene if there is another bout of weakness caused by market turbulence.
Watling considers it a moot point at the moment, saying the markets have now had their catharsis and the wave of choppiness has in all likelihood passed. Volatility remains high, which is often a great buying signal, and he is optimistic about equity markets.
Krosby is somewhat more skeptical and urges investors to keep an eye on further yen strength, among other measures, as an indicator all may not be well.
"September could be a pretty dicey month," she said.
When Japan's stock market and real estate bubble burst in the early 1990s, it kicked off a vicious wave of deflation that eventually pushed interest rates in that country to zero percent and has kept them well below those in the rest of the world, even during its incipient recovery.
Cue hedge funds, who have made a fortune borrowing in yen and plowing the cash into higher-yielding assets from Icelandic bonds to Australian real estate to U.S. collateralized debt obligations. This works great much of the time, but the popularity of the strategy has made periods of financial turbulence even more chaotic for investors.
"It's like the old saying about picking up nickels in front of a steamroller: It looks easy, but sooner or later you get crushed," said Chris Watling, president of London consulting group Longview Economics.
Currency volatility would seem to be an issue far-removed from U.S. equity prices, but a handful of stock market veterans like Art Cashin of UBS have long warned investors to "watch the yen," remembering the way in which it helped make the 1998 Russian debt default into a far more serious financial event.
Both in 2007 and 1998, currency-specific factors such as the U.S. current account deficit or relative interest rates had nothing to do with starting the crisis itself, but big borrowings in yen greatly worsened the damage.
"It's a tsunami, it's a force unto itself," said Quincy Krosby, chief investment strategist at Hartford Financial. "It helps to exacerbate the effects of a trend in the market when you have a huge unwind."
Estimates of the size of the yen carry trade vary from $130 billion to $450 billion, and even the Bank of Japan doesn't have a full grasp of the sums involved. The notional size of bets made with these borrowings could be much larger through use of derivatives.
Watling and Krosby point out that the rapid unwinding of borrowing in yen was just a symptom of excesses elsewhere in the system and not the proximate cause of recent volatility.
"This was a wave of risk aversion with a carry trade behind it, so it was a source of funds," said Watling. "There's always a source of funds."
But it's more complicated than that. Central banks that find their currency under selling pressure often have their hands tied in terms of avoiding even more painful steps, such as boosting rates. A currency that is too strong can be more easily remedied. Japanese authorities used to intervene massively, but they have been on the sidelines since 2004 as hedge funds were only too happy to sell yen for them as asset prices boomed.
"Essentially, the yen carry trade has done the job of intervening," said Krosby.
Now the question hanging over the market is if the Bank of Japan will intervene if there is another bout of weakness caused by market turbulence.
Watling considers it a moot point at the moment, saying the markets have now had their catharsis and the wave of choppiness has in all likelihood passed. Volatility remains high, which is often a great buying signal, and he is optimistic about equity markets.
Krosby is somewhat more skeptical and urges investors to keep an eye on further yen strength, among other measures, as an indicator all may not be well.
"September could be a pretty dicey month," she said.
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