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Yen Carry: From a Little Spark Bursts a Great Flame

In Asia, 愛 (love) is not a word to be taken lightly. The very force that renders it so wonderful can backfire and make you look insecure or desperate or even manic. Used in that cultural context, it is a word imparting violent intensity which English, with all its plastic resourcefulness, has trivialized into a mere shadow.

The yen carries a kind of intensity which other currencies cannot match. The violence of a yen carry unwind is a recurrent theme that you can count on and so saw it last week. When it expresses itself, fixed income must beware.

I wrote about this last year. Japan has an aging and wealthy population and as such has an income and security bias. The BOJ, in trying to break this bias by purchasing JGBs and other assets, has depressed yen denominated yields to levels which do not generate meaningful returns. The combined desire for 1) income and security and 2) miserable yen-denominated yields incentivizes Japanese investors to eye the higher interest rate differentials in bonds denominated in other currencies. Japanese investors trade the FX risk and credit risk for the yield pick-up. This is the carry trade. The collective act of purchasing FX (to buy the bonds) implies a short yen position that reverses in a massive short squeeze when the right tinder is lit beneath it. And then they start taking on FX risk again.

Greece was the right tinder. You saw the EURJPY spike by 3% on the June 28 market open. Investment grade euro corporate credit and its liquid credit index derivative have converged to its North American counterpart in part moving with EURUSD and in part due to the down-stream effect of the yen carry unwind. You see heightened volatility in the index and choppy mean-reverting moves.

Itraxx Europe is a massive liquidity source in the credit space, so it is nearly impossible for it not to mean-revert. What is clear is that the huge move in the yen signaled a huge move in euro-denominated credit because Japanese investors are some big-time buyers of French OATs, Spanish Bonos, and Italian BTPs. These government bond yields provide reference rates that corporate credit marks up.

While euro credit took the brunt of the carry unwind, the Greek event impacted even home currency credit. Carry unwinds can turn into a short squeeze that transcend FX risk.

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