Mrs. Watanabe and the Yen carry trade…

1.)  Who is Mrs. Watanabe?

2.)  What is the Yen carry trade?

With the sub – prime crisis, liquidity problems in global financial markets, U.S. interest rates falling, Bernanke and the Fed dropping money from helicopters in an effort to inflate away the US debt problem, and rogue traders in France making Nick Leeson look like a lightweight, something generally bad could be said to be going on with the global economy.   The general havoc and perceived risk in the turbulent markets have all led to a frightened Mrs. Watanabe, the unwinding of the Yen carry trade and a strengthening of the Japanese Yen.

In an effort to kick start Japan’s post bubble economy; the BOJ has for a long time maintained an interest rate of zero or close to zero percent.  The deflationary period has been a long and prolonged one for post bubble Japan, the post war miracle economy has slumbered along of late, unable to shake itself free from the after effects.  Debt laden companies and a banking system struggling to cope with the sheer size of the write offs have slowly, through banking system reform and a carefully guided path from the red to the black, been able to slowly restructure or readjust to a situation resembling healthy.  Having learnt their lesson the hard way though, even a zero interest rate policy has not encouraged much borrowing, they have grown cautious, and rightly so, of taking on new debt.  Even the general population, in contrast to the credit card, ARM happy masses in the US and UK, have shunned borrowing.  With no wage increases to speak of, even pay cuts in some cases in reaction to the deflationary situation, the average Japanese consumer has refused to borrow in large enough numbers to get the economy moving.

Meanwhile, interest rates in the US, UK, Australia and New Zealand have been comparatively high.  In this situation it makes sense for the average Japanese housewife; who generally holds the purse strings to the family finances, to swap her Yen for Dollars or Pounds and reap the benefits of the international interest rates.  This phenomenon has grown to such proportions that currency traders, noting the effect, have named her “Mrs. Watanabe” and have been trying to second guess her next move for some time.

Receiving 5% on your savings instead of 0% is, of course, only beneficial when the Yen exchange rate remains the same or is weakening relative to the other currencies involved.  Mrs. Watanabe, selling Yen in the currency markets weakens the currency, helping her gain even greater profits when it comes time to convert the trades back to Yen.  The first Mrs. Watanabe out is “quids in”, but the last out has to write off any gains from interest rate differentials against the losses from a strengthening Yen.  It’s not just Mrs. Watanabe who’s being playing this risky game either.  Vast sums have been borrowed in Yen and converted in the forex markets to invest in a variety of different markets in search of a quick profit.  It is not surprising that peaks in carry trading correspond with peaks in the Dow.

As a result, a lot of people have a close eye on the Yen carry trade phenomenon.  A side effect is a beneficial boost for Japan’s numerous export led companies, with the stock prices of Toyota, Honda, Canon, Sony, Nintendo etc. all moving up to reflect the increase in profits expected from a weakening Yen, but the real story is pay back time.

When the Yen carry trade unwinds; which it definitely has done to a large extent already, the last out could face huge losses (in 1998 a Yen carry unwind caused a 30% change in exchange rate against the dollar).  The money to repay lenders of Yen has to come from somewhere.  This situation, in combination with sub prime, general lack of liquidity in the worlds financial markets, the Fed dropping interest rates and increasing the money supply of dollars as it is doing in an effort to inflate away the US foreign owned debt problem spells bad times ahead.  There’s just no incentive to invest in such a risky situation by borrowing (an increasingly strong) Yen anymore, the carry trade, despite interest rates remaining near 0% in Japan is temporarily dead.  Not even Mrs. Watanabe can save us now…