by FN Arena

The carry trade has been a feature of economic commentary related to the Japanese market in recent weeks, thanks in large part to heightened speculation of impending interest rate increases that, in theory, should see some unwinding of such positions.

The thinking of most experts is the so-called carry trade, where investors borrow in a low interest rate environment (interest rates are effectively zero in Japan) to reinvest in higher yielding securities, will be unwound as many people have taken short positions in the yen to finance their investments in other markets and assets.

As GaveKal research points out, such an unwinding may not necessarily occur if the Japanese government continues to support a trading band for the yen of 105-120 against the US dollar. The reason, the independent researchers suggest, is by ensuring the maintenance of such a trading band also ensures there is a positive return in putting on the carry trade.

There are additional implications from this decision to support the yen against the US dollar, the most serious in GaveKal's view being it has undermined the attempts by the US Federal Reserve to limit liquidity in the financial system and thereby slow consumption, which is contributing to the US debt imbalance.

The attempts have not worked as planned, as while the higher interest rates in the US have led to a decline in its housing market this has not flowed through to a slowing in either US or global growth, which remains strong thanks to the Japanese pumping liquidity into the system. This liquidity is finding its way into the global market, so offsetting the impact of tighter monetary policy in the US. To put this in perspective, GaveKal estimates the combination of quantitative easing, the zero interest rate policy and the maintenance of a trading band for the yen has led to US$1.8 trillion entering global capital markets in the past decade, which is equal to about 15% of US GDP.

As a result, GaveKal suggest investors now need to focus on a global yield curve, not a yield curve in any one country. Evidence of the suitability of this approach is clear if you assume the current international yield curve is a measure of US rates less Japanese rates, as this measure gives a much better guide in terms of leading indicators for the global economy.

So what needs to happen going forward? GaveKal suggests with inflation becoming more of a concern thanks to higher oil and commodity prices and wage pressure in some countries, interest rates need to tighten in Japan to bring an end to the excess liquidity in the global economy.

This is potentially underway with the ending of the zero interest rate policy and the expectation a rate rise could come in the next couple of months, so the trend for the yen may indeed be higher. But any significant revaluation of the currency and/or change in Japanese interest rates, and the potential impact on carry trade positions this could have, leads GaveKal to suggest the least risky position to take at the moment is being long the yen, Japanese bonds and other Asian currencies. Copyright FNArena/The ASIA Miner.