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Monday September 14, 2009 - 18:48:00 GMT
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Funding in Dollars

The yen carry trade was one of the great runs in modern currency history. A long position opened in late in late 2003 and held until mid-2007 appreciated over 30% in capital and could have earned upwards of 7% a year on the interest rate spread. At the trade’s height from mid-2005 until the summer of 2007 the trajectory of yen crosses rose with barely a correction.

Japanese rates in that period never rose above 0.5%. The worldwide lure of yen funding was not only the extremely low cost of money but the knowledge that the Bank of Japan (BOJ) could not raise rates.

Interest rates in the United States are the equivalent of the zero rate policy in Japan.   If the Fed cannot raise rates because of anemic US economic growth will the dollar replace the yen as the world funding currency?

The extended period of effective zero interest rates in Japan was the financial rationale for the carry trade. But low interest rates alone did not account for the longevity of the yen carry trade. Long positioning in the carry returned the rate differential and trading interest and easy credit for speculators kept the crosses moving higher. But equally important was the trap that the Japanese economy held for the BOJ.  The Japanese central bank could not raise rates. The performance of the Japanese economy since 1989 and her political reality precluded it. Currency traders enjoyed a more than reasonable conviction that whatever BOJ officials might say Japanese rates would stay low.

Japan’s lost decade began in late 1989 when the Bank of Japan sharply raised interest rates to combat a credit fueled bubble in the property and stock markets. Both markets crashed. Twenty years later neither have regained the prices of that decade. But having engineered the calamity the Japanese government did not insist on the rationalization of insolvent banks and industrial companies. Banks were kept alive with government aid and falling companies were supported by bank loans and subsidies. Economic growth ground to a halt. 

From 1995 onward the main Japanese interest rate set by the Bank of Japan was never higher than 0.5%. But the extremely low rates did not spur economic growth. The zero rate policy which the bank began in 2001 to counter price deflation and foster economic activity accomplished neither goal. 

It was the boom years of the world economy in the middle part of this decade and the external demand for Japanese goods that dragged the export dominated Japanese economy out of its self-inflicted doldrums.  With the collapse in world demand last year the Japanese economy was again trapped by its export model.  Fifteen years of massive government spending and little economic reform has only succeeded in raising the Japanese debt level to the highest in the industrial world without building a solid domestic base of consumption.  Japan’s lost decade could well become permanent if world demand for Japanese products does not recover

In order for the dollar to become the world’s long term funding currency, as the yen was for the better part of the decade, low interest rates are not sufficient.  Markets must also become convinced that US rates will stay low for a prolonged period; that period is probably well beyond the horizon currently implied by Fed Chairman Bernanke.  Whatever the problems of the American economy markets are far from convinced that a ten year Japanese economic morass awaits the United States.

The currency reaction to the financial crisis and its logic has been well documented.  Overnight the dollar and the United States Government became the repository of much of the world’s portable risk capital.  The majority of that temporary capital infusion has now left the US seeking investment elsewhere in the world.

The Federal Reserve response to the sub-prime housing problem began two years ago in September 2007 when it cut rates 0.5%.  Since then the Fed has taken US rates effectively to zero and supplied enormous amounts of liquidity to the economy, initially to stave off economic collapse and subsequently to secure economic growth.  

But the US economy, despite massive losses in property and equities and continuing job destruction, is not facing the economic stasis of Japan’s lost decade

The US economy is larger and more diverse than Japan's. Exports do not dominate the economy. The US population is growing and domestic consumption is the bulk of GDP.  The US financial and economic system is far less controlled by the central government and economic rationalization of banks and companies is taking place.  The US will probably not have a large number of companies kept alive with permanent government subsidies.  In short the US economy is still expected to recover and to grow next year. The Fed will not have to keep rates below 0.5% for a decade.  Far more likely is a Fed rate hike cycle beginning in late 2010 or 2011.

The dollar will not become the new world funding currency as long as the US economy performs within a range of its historical potential. If traders thought there was a good chance that the Fed would be forced to emulate the BOJ zero rate policy for ten years then the dollar would already have seen far heavier losses than it has.

Traders are not yet betting on a lost decade in the US.  Until they do the dollar will be a funding currency only until the Fed first hints at higher rates  The world will borrow cheaply in the US as long  as it can, but there will be no five year carry trade punishing the dollar, at least not yet.

Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst

[email protected]


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