Business Analysis: Climb in the yen leaves burning smell in the air

'The massive investment in carry trades is like stretching an elastic band and hoping it does not snap'

There's a whiff of something in the air. It doesn't smell like panic yet, more like thousands of fingers getting badly scorched. The source of the stench is the rapid unravelling of the yen carry trade, the punt that has proved highly lucrative for both hedge funds and "real" City money in recent years. Last week's sharp correction in equity markets was an abrupt reminder that market risk is alive and well, triggering a stampede to cover short yen positions and driving the Japanese currency to its highest against the dollar for three months.

Like most things financial, the carry trade sounds esoteric but is really quite straightforward. Investors take advantage of Japan's rock-bottom interest rates (currently 0.5 per cent) to borrow yen cheaply and then invest in higher yielding overseas assets, selling the yen for the destination currency. Assets ranging from US Treasury bonds to swanky Mayfair apartments , from precious metals to fine art, have enjoyed record runs fuelled by these carry trades, all at the expense of the yen. For as long as the global economy seemed robust and market volatility low, it seemed a strategy that couldn't lose.

All that changed last Tuesday when global stock markets began plummeting. What had seemed like a one-way bet suddenly became a two-way risk and investors, mainly hedge funds at that stage, scrambled to unwind their carry trades. Having languished at 21-year lows, the yen shot up by 2 per cent against the dollar, posting its biggest one-day jump in 14 months. By the end of last week, it had rocketed by 4.5 per cent against sterling, its biggest weekly gain for more than seven years. Yesterday, investment banks' trading desks joined the fray as the yen surged to 115.16 against the dollar and 221.30 against sterling, levels that triggered stop-loss orders.

"Carry trades are reliant on continued low financial market volatility," said Chris Turner, the head of foreign exchange strategy at ING. "Last Tuesday was a wake-up call that volatility may rise as we move into the late stage of the business cycle, which will make carry trades less compelling.

"We should expect a period of more volatility and events like this will become more common, particularly over the next three to four weeks. The style of correction in these carry trades will be short, aggressive and violent."

Chris Furness, currency strategist at 4Cast, said: "We've reached levels on yen crosses which, if you'd have predicted them a week ago, I'd have laughed at you. What we're seeing is people taking risk off the table. Nothing fundamental has changed, just appetite for risk. It will come back again but, in the meantime there's quite a lot of pain."

Mitul Kotecha, the head of foreign exchange strategy at Calyon, added: "The massive investment in carry trades is rather like stretching an elastic band and hoping that it does not snap. Investors will need a lot of patience and deep pockets in this environment, especially as the one-way bet is no longer likely to persist in the coming months."

We've been here before. The last time the yen carry trade was in the spotlight to this degree was a few weeks prior to Russia's debt default and the collapse of Long-Term Capital Management in 1998. Then, the yen, which had been weakening for months, surged 20 per cent, prompting anyone who had borrowed cheaply in yen to rush for the exits, sparking a massive sell-off in financial markets worldwide in the process. It was as though the Bank of Japan, having supplied cheap funding to markets everywhere, suddenly recalled all its loans.

David Bloom, currency strategist at HSBC, argues that the unwinding going on now is much less serious. He says the current move is a rational result of the downgrading of the prospects for US growth, a reassessment that has been reflected in all financial markets, not just foreign exchange. The situation in 1998 degenerated into blind panic. "A 'true' carry trade unwind is an irrational closing of positions due to fear," he said. "What we are seeing at the moment is a rational result of reduced expected returns."

Most experts also argue that the fall-out from the yen's rally should be less cataclysmic this time round. The big lesson that has been learnt from recent market wobbles is that as long as the economy is sound, the turmoil will remain largely confined to financial markets. Yes, a few hedge funds might take a bath but the economy should escape reasonably unscathed, notwithstanding last week's recession doom-mongering by Alan Greenspan, the former US Federal Reserve chief. Japanese exporters might suffer a bit from having their super-competitive status undermined, but the yen remains very low.

Nevertheless, nerves are jangling and one problem is that no one seems quite sure how much money is at stake. Japan's top financial diplomat, Hiroshi Watanabe, last week estimated the size of the carry trade was between 10 and 20 trillion yen (£45bn to £90bn) but some estimates put the figure at $1 trillion (£520bn). There are no official figures. Mr Watanabe also sought to soothe concerns, saying there were no signs that traders were rushing en masse to unwind carry trades. "We don't have any sign of herding or bandwagoning. I don't think it's a concern for me," he said.

The big question is where we go from here. Predicting currency movements is notoriously a mug's game but we can say fairly confidently that the next step largely depends on how long the slide in equity markets lasts. The smart money is on further gains for the yen.

Adrian Schmidt, currency strategist at Royal Bank of Scotland, said: "Purely in terms of positioning, I think there is still more there. These things have their own momentum and valuation-wise sterling is still, on our measures, about 15 per cent overvalued against the yen."

Other analysts suggest, however, that individual Japanese investors are still selling the yen in volumes that are larger than hedge-fund buying, which will keep a lid on its rise. These retail investors are said to have significantly increased foreign exchange margin trading - allowing them to trade several times their own funds put down as collateral - to buy dollars and sell yen to take advantage of interest rate differentials. Between 22 February and 1 March, such yen selling against the dollar amounted to about $7bn, according to estimates by JP Morgan.

Whoever turns out to be right, the big winners are undoubtedly G7 policymakers. If there was one message that they wanted to hammer home at last month's meeting in Essen, it was that investors should be wary of one-way currency bets, a thinly-veiled warning that the yen could go up as well as down. The warning seemed to fall on deaf ears. Now, it is being heard loud and clear.