The size of the global carry trade (once again)

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The Bank of Japan's recent rate hike doesn't seem to have dented the world's appetite for carry trades.  If anything, the BoJ's signal that it won't changes rates too quickly seems to have added to the financial world's already strong desire to borrow yen to buy other currencies.  

That brings up a question that we discussed extensively two weeks ago -- just how big is the yen carry trade? 

Detecting carry trades can be a bit like detecting planets orbiting a distant star.   Because many carry trades are done off-balance sheet – and even the data for on-balance sheet carry trades has its limits (long lags) – sometimes the presence of large trades needs to be inferred from the wobbles that appear in various financial markets.  Just as the presence of a planet is often detected by the way its gravitational pull leads to wobbles in the light from their star  … 

Right now, I see lots of indirect evidence of the popularity of carry trades.   Large Glacier bond issues and large -- perhaps record large -- foreign positions in the Icelandic Krona.  A strong kiwi.   Strong reserve growth (implying rapid capital inflows) in high carry emerging economies like Brazil, India and Turkey.  The FT's concerns about slow Brazilian growth don't seem to be shared by the markets: Brazil could add close to $10b to its reserves in February alone trying to fight carry trade inflows.  A weak yen and Swiss franc.   

The case that there are big yen-financed carry trades out there doesn’t hinge entirely on the large speculative short position that shows up in the data from the futures exchange.

Measuring the size of the global carry trade is fraught with difficulties, not the least methodological.   Are central banks that hold pound reserves but not yen reserves engaged in a carry trade?  Are Japanese retail investors who buy – without borrowing any money – New Zealand bonds engaged in a carry trade?   What of Japanese pension funds who buy US agency bonds for the yield pickup?  

Or are we really just interested in the size of the leveraged carry trade, that is the amount of yen that have been borrowed by various financial market actors – be they New York or London hedge funds or Japanese day traders – to buy higher yielding currencies?

Personally, I suspect both the “real” money carry trade and the leveraged carry trade matter.  If the real money invested in the carry trade ever decided that they needed to hedge or just lost interest in adding to their “high carry” holdings, it would have a large market impact.     

But a fall off in real money outflows is a bit different than a global margin call that require a very rapid unwinding of leveraged carry trade positions.   And, for that matter, different from the risk that those investors who have sold out of the money calls that insure some big carry traders from really big moves in the yen hedge their own position (Tett and Garnham hint that such insurance is common).  Hedging, here, I think, implies buying yen to protect against further rises in the yen.  Such yen purchases, in turn, would add to the pressure on the yen …

That is a long build-up.  I want to turn the floor over to Tim Lee of Pi Economics – the source of the widely quoted $1 trillion estimate for the size of the yen carry trade.   In response to an earlier thread on the yen carry trade, he wrote: 

“The $1 trillion estimate comes originally from a piece of work I did, and I thought it only fair to contribute my explanation for anyone interested. 
 
In the work I accept that guesstimates for the size of the carry trade that can be derived from balance of payments and banking statistics fall in the range US$100-350 billion. However, as has been noted here, it is not necessarily the case that carry trades will show up in these statistics. Carry trade transactions could be on the other side, for instance, of hedging by Japanese exporters in the forward currency market, which would not show up in bank balance sheet statistics. 
 
The one trillion number is less a genuine 'estimate' than an indication of what I believe to be the order of magnitude. My guess is that the outstanding carry trade is probably even larger than this. There are a number of connected reasons for believing this, which I will try to summarise briefly; 
 
1) The big adverse development in the Japanese balance of payments data (IMF data) that occurred subsequent to the massive intervention up to March 2004 was the deterioration in 'monetary capital' (i.e. increase in Japanese banks' net foreign assets). This suggests that it is carry trades that have weakened the yen, not Japanese institutional or retail funds going into foreign securities, and it suggests that the moral hazard created by the intervention was the original cause. 

2) Indications of the carry trade such as Japanese banks' gross foreign assets, cumulative short-term net foreign lending from the Japanese bop, the spec net short position on the Chicago IMM correlate quite well with each other and also with the yen rate. I think these indicators do not tell us the size of the carry trade but they do tell us the direction. Again, these suggest that it is the carry trade that has been responsible for yen weakness. 

3) Carry trade currency relationships are now enormously out of line with fair values. I have the yen about 30% undervalued against the dollar. The Turkish lira I have 130% overvalued against the yen, which is extraordinary. Turkish inflation is 10%, but the lira simply will not go down (bar the episode last spring).  

4) The Japanese MOF/BOJ had to acquire roughly US$500 billion to prevent the yen appreciating up to March 2004. The yen is now much lower in real terms. Logically the amount of intervention next time round is going to have to be much greater - my estimate is roughly US$2 trillion. The idea that the carry trade is, say, only US$200 billion is inconsistent with this in my view. 

5)There seems to be a relationship between the yen and the enormous credit bubble which now completely dominates global financial markets and the economy. In my work I had a chart (mainly for fun) showing the very close relationship between Goldman Sachs share price in dollars and the S&P 500 in terms of yen. There are plenty of other similar relationships I think you could show. 
 
When you add all this together, it is simply not plausible, in my view, that the carry trade could be as small as most observers are saying. The observed impact that the carry trade is having on the currency and other markets is too great. As to why hedge funds, investment banks and others have not been frightened out of it, I think they have 'learned' that it 'always works' in the end, much as technology growth stock investors 'learned' in the second half of the 1990s. They do not see how it could possibly go badly wrong until Japanese rates have been raised significantly, and they see no prospect of that. “  

On the last point, at least, the market consensus certainly seems to be that Japanese rates aren't going to rise far or fast enough to put a real dent in the carry trade.  At least not this year.  Or maybe just not right now.  With both the G-7 and the BoJ rate hike in the rear-view mirror, it seems like a number of people decided to add to their existing bets.  I am interested in what Macro-man has to say on this ...

UPDATE.  Macro-man's specific reaction can be found here.  If any one can help me better understand the BIS data on yen swaps, please do email me -- there is a raging debate on whether the positions reported by the BIS are indicative of the markets' true short-yen position or not ... 

UPDATE 2:  The FX page at bloomberg provides more evidence of ongoing carry trades.   The Swiss franc hit a record low v. the euro.  The Brazilian real headed up, again, in the face of ongoing intervention (I assume).  It is heading back to levels last seen before the emerging market sell-off last may.  And buying insurance against a big move in the yen/dollar remains cheap -- record cheap.  Which means, I think, that it is easy to borrows borrow yen to buy real or Turkish lira and then hedge that position by buying protection against a big move in the yen/ dollar.   That hedge is cheap -- someone is willing to sell a lot of protection.   And the returns on Turkish lira and Brazilian real carry trades are large.  

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