Japan's low interest rates and weak currency have been credited for helping generate the sea of cheap cash that has buoyed global markets, but worries about an imminent and devastating end to the so-called carry trade may be overstated - for the time being at least.
Signs that currency players are moving to cover the risk of a rebound in the yen amid protests from European policy makers about its weakness have prompted concerns that a spike in the yen could again cause shockwaves throughout markets. Assets from equities to emerging market and corporate bonds and from commodities to real estate have enjoyed record runs fuelled by ample global liquidity.
But analysts say much of that liquidity is being fed by buying of bonds by Asian central banks and oil-producing nations, which has kept bond yields low and hence risk appetite high.
Company earnings have also been growing at a record pace, with much of the cash being used to bolster balance sheets, keeping stock valuations in check and limiting the risk of widespread debt defaults. Max King, a global strategist at Investec, said the carry trade was a symptom and a contributor of global liquidity but not the root cause. "It is a pillar, but it's one of many pillars."
Japanese benchmark interest rates at 0.25 percent have attracted borrowers both domestically and internationally who then exchange their yen for currencies such as US dollars, British pounds or New Zealand dollars, where interest rates are up to 700 basis points higher.
Obtaining definitive data on how widespread such trades are is nigh on impossible. But figures on how much non-Japanese banks are borrowing in the Japanese call market, and the net position in high yielding currencies such as sterling and the Australian dollar minus low yielding yen and Swiss franc suggests levels are at or near record highs.
Philip Watson, head of investment analysis and advice at Citigroup Private Bank, believes the Bank of Japan will raise interest rates to perhaps 0.75 percent this year - still significantly lower than other major markets and not enough to derail the carry trade.
"Any moves in excess of what the market anticipates (for rising Japanese interest rates) are likely to rock the boat a little and add a cost to the whole carry trade, but having said that it does not look right now like the Japanese central bank will move aggressively in the next few months," Watson said.
Rob van de Wijngaert, an investment strategist at ABN Amro Asset Management, said the Bank of Japan might hold off on interest rate hikes until after elections in July. "In light of the most recent consumption and CPI data the BOJ is unlikely to grab the opportunity to hike in February," he said.
"That is good news for the Japanese carry trade and for riskier assets," including emerging markets, high yield bonds and currency spread trades, he said. Such riskier assets have already enjoyed an extended period of strong returns and low volatility.
Equities have surged, with the MSCI All-Country World Index trading at record levels, having more than doubled since its lows in March 2003, while its Emerging Markets stable-mate has more than trebled over the same period of time. Spreads of corporate and emerging market bonds over risk-free US Treasuries have narrowed to record tight levels, and volatility, as measured by the Chicago Board Options Exchange Volatility Index, has fallen from around 30 percent in 2003 to below 11 percent now.
Traders betting on yen weakness have also benefited, with the Japanese unit tumbling 16 percent to record lows versus the euro above 158 yen over the past three years. Such trades have certainly been popular, with industry data last week showing record speculative short yen positions.
That makes the yen more vulnerable to a sharp reaction, and history shows the propensity for violent moves in the Japanese unit. In October 1998, prompted by the Russian debt crisis and the collapse of hedge fund LTCM, the yen jumped as much as 25 yen in just four days.
Rapid appreciation of the yen also accompanied the broad-based market sell-off in mid-2006 as the Bank of Japan raised interest to 0.25 percent from near zero. There is a danger that conditions similar to May 2006 may be returning, with equity valuations becoming less attractive, US bond yields rising and the yield curve steepening.
Such conditions could prompt another extreme reaction if the yen were to reverse suddenly. "People are quite happy to take on risk over a long period of time but do tend to try to squeeze through the exits simultaneously," said Peter Lucas, global investment strategist at Jersey-based fund manager Ashburton.
"The one thing that gives me some degree of confidence that it won't be a disorderly transition is the fact that so many people are talking about it - it's not going to be a bolt out of the blue."
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