Simplifying the Yen Carry Trade

We've all heard about the yen carry trade, but for most investors, it remains one of those elusive ideas from the realm of hedge fund managers. But normal investors can use the dynamics of the yen carry trade to their advantage as a hedge against any further meltdown in the U.S. markets.

The yen carry trade is not complicated. The concept revolves around a play on currency yields. It consists of borrowing a low-yielding currency and investing the money in a currency that is offering a higher yield; the difference in yield represents your gain.

Hedge fund traders have been borrowing extremely low-yielding Japanese government debt and using the money to buy higher-yielding U.S. government and corporate debt for quite a while. If the domestic bond market is running into a real liquidity crunch, we may see the yen carry trade start to unwind. This means that traders will sell U.S. Treasury and corporate debt and buy back their short Japanese bond positions.

The unwinding of the yen carry trade will weaken the bond market domestically and drive Japanese debt higher. Higher prices for Japanese government bonds should drive the yen higher vs. the dollar. Did you get that? In short, if the subprime mess escalates from here and the disaster widens, investors can use the yen as a hedge against their portfolio.

The yen hasn't been the strongest currency lately, but it's stronger than the dollar, and that's what's important for this trade. Japan is benefiting from the bullish "halo" effect of China. Chinese hypergrowth is spilling over into the rest of Asia and has served to pull Japan out of its malaise.

U.S. Dollar Index

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If the subprime mess starts to slow down the domestic economy or move the economy into a recession, the yen should rise on a relative basis vs. the dollar. If we look at a chart of the yen, we can see that it has drifted lower most of the year, but turned up in July as the subprime situation came to the forefront.

Currency Shares Japanese Yen

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The currency has rallied since July and continues to hold the short-term uptrend. The short-term outlook for the yen is bullish and the intermediate-term outlook is improving. Traders can buy the yen by getting long the Currencyshares Japanese Yen (FXY Quote) ETF.

If the credit crunch continues to expand and becomes a much larger problem, then the unwinding of the Yen carry trade should continue and traders can buy the Yen as a hedge against the weakness in the U.S.