The yen can provide a key hedge in a world which consists of continuous intermittent bouts of unwinding leverage. But, I do think the Fed’s recent actions during the Bear Stearns affair helped bring a modicum of confidence back to the credit markets.

The yen dropped again in overnight forex trading early today on word that the carry trade is once again gaining momentum.

A wholesale resumption of yen selling to fund renewed appetites for riskier investments is just the latest reason why I see a pullback in the yen coming soon, after soaring since February.

Don’t get me wrong, I still like the yen long-term. The yen can provide a key hedge in a world which consists of continuous intermittent bouts of unwinding leverage. But, I do think the Fed’s recent actions during the Bear Stearns affair helped bring a modicum of confidence back to the credit markets.

I also think the Fed’s steps were unusually well thought out – especially given the rather crazy credit-creation-driven monetary system we now live in. In short, is it time for the carry unwind to take a breather on some risk seeping from the system?

As you may remember, for years, investors and traders all over the world have borrowed Japanese yen to invest in higher-yielding assets (i.e. the popular “yen carry trade.”).

But there’s one problem. This yen carry trade only works as long as the markets steadily increase for a period of time. Once markets correct, yen carry trades “unwind,” meaning traders must pay back the Japanese yen loans, and push the yen higher. That’s exactly what’s been happening lately.

The Last Time This Happened -
Savvy Investors Made 46.7%

Below is a chart of yen-dollar (not the usual dollar-yen you are used to seeing). This chart compares the yen’s move the last time we saw a significant carry trade unwind. This particular carry-trade unwind happened 10 years ago, just after the Asian Financial Crisis. The crisis effectively unwound the carry trade and the yen surged 46.7% against the dollar.

We then looked at where the yen was before the unwinding carry trade began in 2007. This time, of course, the sub-prime credit crunch triggered the carry-trade unwind. Assuming the yen leaps as much as it did 10 years ago, i.e. 46.7%, then the yen-dollar pair could reach the 118.00 level. For now, it’s resting right around 101.25.

Sure, it is a bit simplistic to say the yen will rise 46.7% against the dollar this time around. But when you consider the carry trade was about seven-times larger in 2007 than it was in 1998, it definitely seems possible. Also the credit crunch and unwinding of leverage is more pervasive than the Asian Financial Crisis. So I think it increases the probability this simple analysis could play out, and shoot the yen-dollar pair higher.

That said, another thing you may notice about the chart above – it’s looking parabolic! How much longer can the yen march straight up against the dollar (and push the USD/JPY currency pair straight down) without taking a breather?

Below is a summary from the Commitment of Traders Report (CME Long Form) that shows the open interest in the Japanese yen for Non-Commercial speculators, like me:

Mr. Market’s Law – Almost as Sinister as Murphy’s Law

Now we all know how sinister and sadistic Mr. Market can act at times. You can tell because Mr. Market likes to wait for the maximum amount of players to commit to a certain trade before he delivers an ugly blow.

Open interest shows us how the majority of traders feel about a particular position. These numbers tells us how committed traders are to a particular position. The numbers also give us some insight on when Mr. Market is about to deliver a stiff backhand to the jaw of those traders who are a little too married to their position.

At 76% long, we may be inching ever so closer to backhand time. But be warned: the headlines won’t read: “Mr. Market Slapped the Punters.” Instead, we will see something such as: “Profit taking in the Yen.”

And if we see “profit taking” in the yen, where might traders move those profits over the near-term? Maybe into a commodity currency with yield and growth – two things valued in a world if credit isn’t frozen solid.

Where the Yen Profits Will Flow Perhaps?

Above is a cross-rate chart of Australian dollar compared to the Japanese yen. It shows the Aussie peaked at around 108 against the yen back in October 2007. The Aussie has been losing ground against the Japanese yen ever since. It’s now trading near 91.

Maybe it’s a decent risk/reward setup. Key word that is, as usual, “maybe.”

JACK CROOKS, Editor
World Currency Options

EDITOR’S NOTE: Are we in for more market risks this year? Our investment editors, Mike Burnick and Eric Roseman certainly think so. If so, carry traders will be knocked out of the park once again. But those that take advantage of this next yen correction will be in the perfect position to profit from this latest round of carry trades – as they come undone later this year. Read our NEW special report right now to find out how you can be one of these savvy investors.