The Fate of the Carry Trade

Concerns over its unwinding are overstated, says S&P

It’s a liquid planet, in more ways than one. Low global inflation, China’s $100 billion in foreign exchange reserves, and a growing reservoir of Middle Eastern oil dollars have created an ocean of liquidity. The result, in our view, has been increased risk tolerance, lower equity volatility, and excellent returns in higher-risk asset classes.

Most important, ample liquidity has helped keep interest rates low around the world. Among the major economies, Japan’s monetary policy — thanks to lingering concerns about deflation — is by far the most accommodative.

Bolder market participants have taken advantage of this interest rate disparity in a strategy known as the “carry trade.” An investor borrows money from a low-interest-rate country like Japan and invests it in a country where interest rates are substantially higher. Profit is obtained from the spread between the rates. In addition, a weak yen, resulting from the Bank of Japan’s reluctance to aggressively raise rates, has enhanced the carry trade’s appeal.

The outlook for Japan’s economic growth, and its impact on the Bank of Japan’s monetary policy, has far-reaching implications for global capital markets. This was evidenced last May, when global markets plunged amid concerns over growth prospects and the possibility of tighter policy from Japan’s central bank. Markets have since recovered — but the concerns remain.

Japanese interest rates are headed significantly higher, according to the naysayers. In this scenario, the wide rate spreads that have fueled the carry trade in recent years would shrink. In addition, more competitive rates would allow the yen to appreciate sharply, thereby undermining the rationale for shorting the Japanese currency.

The bears believe the potential removal of the liquidity derived from the carry trade could result in a sharp rise in volatility, as investors shun stocks in favor of lower-risk asset classes like cash.

While S&P Equity Strategy believes the yen carry trade’s popularity has probably peaked, we expect it to be unwound gradually, with limited negative repercussions for global capital markets. The reason for this is twofold. First, we are skeptical that the Bank of Japan will tighten aggressively. After a decade of falling prices, we believe Japanese interest rates will rise only gradually, as the central bank awaits further evidence of an end to deflation. In addition, we believe Japanese economic momentum is faltering somewhat, precluding a more hawkish monetary policy stance.

Second, we think the expected anemic pace of rate hikes will keep the yen from appreciating too sharply or too quickly, especially given the faster pace of tightening we expect from the European Central Bank and the Bank of England.

S&P believes this is good news for global equity investors. Our global asset allocation remains unchanged with a healthy 60% equity weighting, of which 40% is domestic and 20% international. Our recommended international weighting includes 15% in developed-country stocks and 5% in emerging market equities.

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