Yen Carry Trade End Likely to Hit Hedge Funds Hard

"Men are not prisoners of fate, but only prisoners of their own minds."

Franklin D. Roosevelt (1882-1945) U.S. President

The Yen currency rate is on the move and taking no prisoners. The script is the same. Previous crises, like the 1987 stock market crash, the 1998 Asian Crisis then in Sep 2008 following the Lehman collapse and onset of the 2008-2009 Credit Crisis all led to the yen marching higher.

Fundamentally, risk-averse Japanese investors repatriated vast portfolio assets back to Tokyo from overseas accounts, often with a bit of a lag. This included big institutions such as insurance companies and pensions. But it also extends to retail investors too.

The sheer size of the moves taking the yen to new highs across a whole host of cross rates is unprecedented and is likely to have steamrolled a number of hedge funds and other investors that have played the carry trade (short yen) for months (and years) utilizing low cost borrowed fund to leverage the trade. Many now face the stark reality of imminent margin calls and the forced selling of other liquid assets to raise cash. So much for all those that interpreted recent tragic events as a yen "selling opportunity".

Japanese retail investors in their search for global yield are or were an important component in the global carry trade. This involved borrowing funds in a low interest rate currency to purchase an asset in a higher yielding currency. Over the last 10 or so years Japanese "orphans and widows" piled into Aussie, South African and Brazilian bond funds. These were eagerly pushed by domestic brokers, banks and insurance companies eager to drum up business against formidable postal deposits and in spite of miniscule interest rates afforded by domestic JGBs (Japanese Government Bonds).

Once the natural and man-made catastrophes hit a flight to safety was triggered. Many accounts sold off.

Aside from bonds, Japanese institutional investors were big buyers of structured products; big buyers of sub-prime CDOs, European equities, U.S. municipal paper and USTS. Again, once disaster struck they sold.

Additionally, local banks in Japan are known to hold about $1 trillion worth of Japanese equities on their books. For many of them the all important "uncle point" or breakeven for them on the TOPIX Index is at 800. This may explain why the BOJ is believed to have bought aggressively various Japan equity-related ETFs once the index slumped to around 725 on March 15. The BOJ is now expected to have spent $2.6 trillion in price support activities in stocks and bonds to lift markets and reverse the negative price spirals. But even they might be running out of fire-power.

Anecdotal evidence suggests that some of the biggest hedge funds (based in Greenwich, CT and Chicago) have been the biggest players in the Japan yen trade. Expect possible big losses to be reported in the March end performance numbers, in much the same way that there were divergent performance numbers during the previously mentioned crises. Brave players will already have pulled out and will be playing a yen-trend buying game short-term. Mahalo.