Frequent trading question-asker Rod is back with another one. He sounds worried that he’s asking a foolish question, but it’s hard to get better and more knowledgeable if you’re afraid to ask when something confuses you. Fortunately for me, his question isn’t too hard to answer. 🙂
I know, you will slap me for this, but I have to ask: I don’t get it, why is the Japanese Yen still a safe-haven currency? To put it similarly, why is the market still in love with Japanese Government Bonds?
Is there no credit risk in JGBs? With 200% Public Debt-GDP?
As always, thank you.
This question is clearly motivated by the big gains the Yen experienced Thursday as the stock and other markets were coming unglued and a serious risk aversion/flight to quality move was afoot.
What Rod has done, however, is forgotten something important – the carry trade. A considerable amount of yen has been borrowed and exchanged for other currencies (the Aussie being a favorite given the exchange rate differential) to be invested there. What Rod has viewed as a flight to quality to the yen is in fact a reversal of the carry trade.
The carry trade gets done when one currency can be had for very cheap (like the JPY) and the markets feel comfortable with the level of volatility and prospects for positive returns. As investors and traders get more relaxed and complacent about things they continue accumulating carry positions, forgetting about the risk side of things – rather link traders who stop thinking about how much they could lose and focus too much on how much they can make. When something happens to snap them back to reality, they start cutting back their exposure. This could be either from them worrying about the returns on their invested funds or concerns about the impact on their positions of a turn in currency exchange rates.
At this point the carry traders are nervous about their investments and are reducing risk. That means selling stuff they are holding, moving out of the currency they have switched into and back into the one they borrowed. That means selling stocks and other instruments and converting their AUD and other currencies back into JPY. When it happens en masse, as it has been of late, the JPY pairs get hit hard because of all the yen buying.
This is not a flight to quality run into the Japanese currency. It is simply traders and investors paying back yen-denominated loans. This is a get flat move, not one positioning market participants long the yen. The flight to quality was actually into the dollar and US Treasuries.