Tuesday, March 20, 2007

The Other Side of the Carry Trade Coin

Yesterday, I looked at the relationship between volatility and the value of the Japanese Yen. I argued that "carry trade" provides the link between the two. When volatility increases, speculators holding short positions on Japanese Yen and long positions on other currencies get nervous and reduce their positions. This reduction in carry trade causes the Yen to appreciate.

But what about the other side of the transaction? Carry trade entails borrowing Yen at low interest rates in order to invest in other currencies offering higher interest rates. If carry trade is driving the Yen exchange rate, then surely it is also driving the exchange rate of the "other" currency (or currencies) that these speculators are investing in.

One key currency that might offer evidence of this is the New Zealand Dollar. While the Yen has the lowest interest rates among developed economies (the trend-setting central bank rate is 0.5%), New Zealand has the highest (just increased last week from 7.25% to 7.5%). Also, while the New Zealand economy may be small (according to http://www.photius.com/rankings/economy/gdp_official_exchange_rate_2007_0.html, it ranks 49th in the world by GDP- between Chile and the Philippines), it has no capital controls and a clean floating exchange rate- with no Government intervention in exchange rates for many years, making it an attractive target for speculators who want to be able to move their money around freely. According to http://www.ezinearticles.com/?Which-Are-The-Top-Forex-Currencies?&id=473454, it is one of the 8 most traded currencies in the world!

The figure below shows that the New Zealand Dollar moves in inverse to the Japanese Yen, especially since late-February (note that one of the exchange rate series is already inverted). Added to yesterday's arguments, this is consistent with carry trade being the main driver of both the Yen and NZD exchange rates at the moment.

Of course there are many other variables that also determine exchange rates: expectations of future economic growth, trade flows, foreign direct investment, etc. But at the moment, in a period where volatility is volatile (!), the importance of these variables pales in comparison to Carry Trade. I expect the world economy to remain volatile for some time, with increasing evidence each week that the US economy is soon to enter recession. If I am correct, Carry Trade will remain the main determinant of many currency values. Once stability to the world economy returns, then I expect to see increasing evidence that other variables matter as well.

1 comment:

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