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Is the Dollar Set to Become the New Yen?
Investors have long borrowed and sold the Japanese currency en masse, using the proceeds to snap up higher-yielding assets outside the land of the rising sun. Dubbed 'the carry trade,' the strategy generated hefty returns until the world economic crisis soured investor bets, sending them scurrying back to buy yen and close out their positions.
Now, some currency watchers say investors are getting tempted into to giving the carry trade another try, only this time investors are considering using the dollar as the base of the trade. That could help explain some of the slide the buck has suffered lately and — if true — it'd likely mean more downward dollar pressure to come.
'The yen-based carry trade is relatively weak,' said Sebastien Galy, a senior currency strategist at BNP Paribas in New York. 'The yen has not picked up and the dollar is resuming and [the dollar] has no clear competitor right now as a funding currency.'
In the currency market carry trade, 'funding currencies' traditionally feature the low interest rates and low volatility traders want. (Volatility in the funding currency can wipe out the spread investors count on for their profits.)
For those reasons, the yen long held a cherished place in the hearts of carry traders. The Japanese currency featured rock-bottom interest rates put in place by the Bank of Japan, which has kept rates low in a long effort to re-energize the Japanese economy.
Unfortunately for the yen, the relentless selling pressure generated by those using the yen as a funding currency helped keep Japan's currency feeble. Some say similar pressures are falling on the dollar now.
'It's one thing that's working against the dollar,' said Philip Simotas, president of FX Concepts, a currency-focused hedge fund. 'It's a great currency to fund out of.'
In late August, by some measures, borrowing in dollars became cheaper than borrowing in Japanese yen for the first time in 16 years. Low U.S. rates, and the depth and liquidity of the dollar make the greenback attractive to traders who want to use it as the base for a carry trade.
To be sure, not everyone buys the notion that the dollar is now playing the part of the yen. 'I think it's certainly become a popular explanation of dollar weakness,' said Vassili Serebriakov, a currency strategist for Wells Fargo in New York. 'It still feels a little bit like trying to fit the story to the facts rather than the other way around.'
But others point to the fact that the prospects for the yen have also grown more complicated lately after the long-ruling Liberal Democratic Party was ousted by the Democratic Party of Japan in a landslide victory in an election in August. The incoming government is thought to be more open to the prospect of a strengthening yen.
Strengthening funding currencies are the last thing a carry trader wants to see. And unlike in the past, carry traders now have options, as central banks worldwide have hammered down rates in a concerted effort to galvanize the economy.
The Fed has also reinforced the message that interest rates will be low for the foreseeable future, and while there are signs of improvement in the U.S. economy, no one seems to be expecting an upturn sharp enough to force the Fed to start to tighten rates soon.
Investors also have noted the torrents of liquidity the Fed pumped into the system during the financial crisis, and are betting that will help keep a lid on the dollar going forward. Traders would rather see their funding currency drop in value, rather than increase, as rises eat into and eventually erase their profits. 'The fact that the U.S. dollar also appears to be in a protracted downtrend is serving as an additional encouragement for people to use the greenback as a funding currency,' said George Davis, chief FX technical analyst at RBC Capital Markets in Toronto.
