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The recent plunge in USDJPY which shaved nearly 1000 points off the yearly highs in a matter of weeks has many currency traders wondering if there is more downside to come.

The drop in USDJPY was not caused by sudden divergence in economic fundamentals between US andJapan, but was driven instead by the liquidation of the carry trade. Looking at  past instances of significant carry trade liquidation  in USDJPY such as the Asian financial crisis in 1997 or the 1998 downfall of Long Term Capital Management fund the initial move down was inevitably followed by a retrace and then a thrust lower as the full impact of the unwind made its way felt though the global financial markets. Therefore the question to consider is whether the recent rebound in the pair is simply a dead cat bounce.  Could USDJPY trade as a low as 110 by October?  We examine several possible scenarios that could create that outcome.

Fed does NOT cut rates in September

At first this may seem as a counterintuitive conclusion. After all, if the Federal Reserve were to cut the funds rate by 25bp or even 50bp in September the interest rate differential between the dollar and the yen would compress seemingly hurting the carry trade. Conversely, if the Fed left the interest rates unchanged preserving the 475bp differential between the greenback and the yen - why would that hurt the carry trade? The answer has more to do with risk rather than rates. The carry trade, especially at this mature period in its cycle, thrives in a low risk, low volatility environment. When investors are content about the present and sanguine about the future they are more willing to assume risk seeking higher returns. Simply put, they are more interested in return on capital rather than return of capital.

With Japanese  interest rates remaining miniscule at 50bp after tonight’s no rate hike decision  by the BOJ, even a half point rate cut by the Fed  would still preserve a net 425bp positive interest rate differential between the yen and the dollar.  Of far greater importance to the carry trade will be the attitude of equity investors towards risk.  If the Fed does not cut rates, the US equity markets could become more volatile as the higher cost  of credit for consumers and corporations would likely contract demand and compress profit margins causing stocks to plummet. A sharp decline in equities would bring back another wave of risk aversion and  along with it more rounds of carry trade liquidation pushing USDJPY lower.

At the time of this writing, consensus is building that the Fed may indeed keep rates steady, as Fed officials continue to make hawkish commentary while most recent economic data from weekly retail sales to jobless claims has yet to show any serious signs of distress in the system.   If the Fed does maintain rates steady and if that in turn creates selling pressure on Wall Street as Dow slowly tickles down to 12,000 then USDJPY will likely follow suit as risk appetite is gradually curbed.

Dow Has -1000 Point Day

The slow and steady drip is of course not the only way that  the carry trade could crumble. Equity investors simply may not wait for the Fed to act and could push prices sharply lower if the problems in the credit markets persist. With fixed income investors still reluctant to finance anything but Treasury bills, the Commercial Paper market as well as the Corporate Bond market may see more episodes of liquidity stress. Given the fact that equity investors are approaching September and October - the two most seasonally turbulent months in the market a selling stampede is not out of the realm of possibility. A one thousand point down day in the Dow – which would be a milestone in nominal terms but not in percentage terms - would no doubt trigger an immediate rate cut from the Fed but at that point it would most likely be too late, as the move would be seen as reactive.  Such a massive decline in US equities would no doubt reverberate around the world causing sell offs in all the major bourses and triggering carry trade liquidation in it wake.

US Economy Slows Markedly

Up to now the troubles on Wall Street have yet to affect Main Street. US economy continues to expand at a healthy pace registering better than 3% growth in the second quarter. However, as the third quarter comes to a close signs are brewing that the problems of the finance economy may be spilling over into the real economy.  The most obvious economic hit comes from the more than 38,000 mortgage related jobs lost over the past month due to bankruptcies and closings of a number of mortgage brokers. However, the longer term effects of the collapse of the housing sector may been seen in the decline of demand  for consumer durables such as furniture, appliances and new automobiles. Furthermore, the near 1 Trillion dollars worth of resets in Adjustable Rate Mortgages coming due over the next 12 months is likely to significantly curb consumer spending, as homeowners will be forced to allocate a greater portion of their income to debt service.

In short, the overhang from the housing sector collapse is likely to weigh on aggregate US demand and could potentially tip the country into a recession if the rate of foreclosures and bankruptcies accelerates markedly. In that scenario the Fed would need to aggressively and continuously cut rates until the economy stabilized once again. Should that occur much of the impetus for the dollar yen carry trade would be gone as traders would anticipate the persistent narrowing in interest differentials and pressure the pair lower.

Conclusion

As markets have stabilized over the past few days and risk appetite and along with it the demand for carry trade has come back, it is important to remember that past instances of carry trade liquidation always  resulted in further declines after an initial retrace.  Perhaps this time the situation may prove different and monetary authorities would be able to restore confidence in the markets while investors from China and the Persian Gulf absorb the risk of the credit failures in order to assure the continuation of global economic growth. However, the scenarios we’ve outlined above are quite plausible given the current market dynamics and currency traders would be well advised to consider them as they ponder the value of the carry trade at the new lower prices.  

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