The Yen Carry Still Matters

This column was originally published on RealMoney on Jan. 4 at 10:00 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

A calendar year can be both a long and a short time. Our collective memory of 2006, compressed already to bumper-sticker size, was that it was a very good year for the markets.

The aggregate numbers say so, and who am I to dispute them?

But how many of us recall the trapdoor opening under global markets in mid-May and staying open until mid-June? At that point, it seemed as if 2006 was going to be a long year.

The villain, for those who wish to impute causation, was the Bank of Japan and its decision, chronicled here in July, to withdraw 21.56 trillion yen from its banking system between February and June 2006.

That would be equivalent to the Federal Reserve draining $188 billion from the U.S. banking system over a similar period.

Short-term rates in Japan shot higher, and emerging market equities plunged. While three-month yen LIBOR continued to move higher all the way into the end of the year -- all the way to 0.5675%, that is -- emerging markets stabilized and managed to close the year at a new high.

Short-Term Yen Rates and Emerging Markets

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Sources: Data from Bloomberg, calculations by Simons

The Yen Carry

The reason for emerging markets' resilience, as we'll see below, is the continued persistence of a positive yen carry. You can still borrow in Japan, swap this currency for a higher-yielding one and pocket the interest rate spread subject to the risk of the higher-yielding currency depreciating too much.

While much of the focus on the yen carry trade has been on the U.S. market, as Japan is one of our largest creditors, the average daily return on the yen carry since the January 1999 advent of the euro has been greatest for emerging market currencies such as the Turkish lira and Argentine peso. Other currencies with major interest rate spreads relative to the yen include the Polish zloty, Indonesian rupiah and Mexican peso. The average daily yen carry returns for 28 different currencies are depicted in the chart below.

Average Daily Return in Three-Month Carry Against JPY January 1999 Onward

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Sources: Data from Bloomberg, calculations by Simons

As high interest rates constitute an artificial prop to any currency, the U.S. dollar included, we should ask whether the large interest rate spreads for the Turkish lira, the Argentine peso and so on have been offset by declines in the spot rate. The answer is yes, but not enough to derail the trades materially. If we add the spot rate gains and losses to the interest rate spread gains, we find that even the biggest spot rate losses are but a fraction of the interest rate spread gains.

Post-January 1999 Decomposition of Yen Carry Trade

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Sources: Data from Bloomberg, calculations by Simons