Carry trade and home bias

One of the key concerns about carry trades is the belief that they are subject to strong reversals if risk or interest rates change. This is not a unique concern with carry trades. If there is a significant amount of one-way persistence in a specific trade idea, there is a belief that the chance of a violent reversal increases. This has been voiced as a special concern with Japan. The yen has been one of the carry trades which have been one-sided for a particularly long period of time. You would have been short the yen for years if you followed a carry trade. While one-sidedness makes many very nervous, the data and market structure suggests that this carry persistence could last for a long time.

Surprisingly, little of the carry flow is coming from the speculative community shorting the yen, but from flows out of Japan from consumers. It is the home investors who have been the biggest contributors to the yen decline because of the rebalancing of their domestic portfolios. There has been a significant home bias in the Japanese markets that is being adjusted with these trades. This process is still in the initial stages so continued financial out flows may occur for some time and dampen any yen rally.

This revision of domestic portfolios is based on two factors. One, changes in the regulatory and structural environment has allowed more rebalancing out of domestic portfolios. With more money allowed to seek other alternatives, investors have been taking advantage of the new environment. Two, the level of domestic risk aversion is high after the long decline in Japanese equity markets. This has had the impact that Japanese investors are less interested in holding domestic equity and looking for what they believe are relatively safe assets in foreign fixed income. These investors may be surprised by the impact of changing exchange rates, but they currently have the belief that holding foreign short-term instruments at higher yields are a good play for additional income.

The fact that Japanese investors are the driver for these carry trades suggests that they will not be as sensitive to yield changes as hedge fund investors. We may not see the quick reversals that have been the hallmark of other carry trades when there is a reversal of interest rate risks.