PARIS: Further unwinding of so-called carry-trades could be triggered if investors re-evaluate risk, and euro zone and Japanese interest rates climb, the Organisation for Economic Cooperation and Development indicated yesterday.
Carry-trades, where investors borrow low-yielding currencies such as the Japanese yen or Swiss franc to fund purchases of higher return assets, have been very much in vogue in recent years, powering target currencies to multi-year peaks.
The Paris-based OECD said in its twice yearly global outlook that a partial unwinding of carry-trades may have contributed to global equity market turmoil earlier this year as investors rushed to cut exposure to risk, although the impact was limited.
“With indications that risk outside the US subprime mortgage markets is currently somewhat under-priced, some re-pricing cannot be excluded,” the OECD report said. “Provided that there is no substantial deterioration in the outlook for global growth or corporate defaults, any adjustment is unlikely to prove disruptive.”
Supporting this, it said, was a moderating growth rate in some measures of global liquidity and expectations for the euro zone and Japan to raise rates in the next 18 months.
The European Central Bank is expected to increase borrowing costs to 4% in June with more likely after that, while further gradual tightening of monetary policy is expected in Japan from its current ultra-low 0.5% rate.
The OECD said it was difficult to gauge the extent of the carry-trade from statistics on cross-border flows, which generally do not point to a recent upturn of outflows from Japan.
It added that most carry-trades were undertaken through fast growing over-the-counter derivatives markets. Outstanding notional positions that involved one half of the trade in yen and Swiss franc amounted to roughly US$4 trillion and US$1trillion respectively in June 2006, the OECD said.
It said there was some evidence pointing to large short positions in yen put options, reflecting insurance sold to those engaged in the carry-trade, with many market participants assuming these short positions are held by Japanese banks. “The need to cover these short positions in the event of a sharp yen appreciation could strongly amplify such currency moves,” it said.
Still, it warned of the potential fallout from a more sudden unwind of the global carry-trade.
“A large amount of outstanding carry-trades implies that any shift in expectations could lead to fairly large, and potentially disruptive, exchange rate swings, with increased volatility feeding into higher interest rates and reduced liquidity,” it said. – Reuters