Carry On

The sky is clearing and the night
Has cried enough
The sun, he come, the world
to soften up
Rejoice, rejoice, we have no choice but
To carry on
-Crosby, Stills, Nash and Young

Well maybe rejoice is not tops on investors’ minds, but one thing is certain: they sure have had enough of the carry trade. The carry trade was simple: borrow money from a country with low interest rates and reinvest the proceeds to one which provides a higher yield. Seems simple enough, so hedge funds and trading desks around the world put the trade on—specifically, they borrowed from the Japanese, who kept interest rates close to zero for some time, and invested the money into emerging markets where returns were dizzying.

And so we enter the next phase of the financial crisis: the moment when the music stops playing and everyone scrambles for an empty chair. In this case, managers were busy unwinding the carry trade at an aggressive pace. As the process started, it then triggered margin calls on traders, amplifying the pressures on them to sell. Add to this fact the underlying flight to quality amid market turmoil and you can see how a massive trade that had taken years to build up (some say there was $500 billion tied up in the carry trade), could unwind in a matter of months.

As a result, the Japanese yen has soared in value—up approximately 30% against the euro over the past month (a 6-year high). While these kinds of moves may have become the norm for stock and commodity markets, they can wreak havoc when they occur in currency markets, because it becomes nearly impossible to price exports or imports. Additionally, investors have to unwind both sides of the trade, which means that as they are re-purchasing yen, they need to sell those assets that were intended to deliver the outsized returns. In this case, the deleveraging and panic that has caused the Japanese, as well as many emerging markets, significant damage. Earlier this week, Japan’s Nikkei index was at its lowest since 1982 and the MSCI index of non-Japanese Asian stocks was down 33% in October. To stop the currency panic, there could be government intervention on the horizon.

The good news out of all of this is that ultimately, the currency revaluation process should lead to a more solid system. It is likely we will hear calls for intervention and oversight of currency trading, but for now, if you are getting gloomy, just hum a few of those lyrics noted above…Rejoice, rejoice, we have no choice but To carry on…”