Simply put, exchange rates are also subject to supply and demand.
If you decide to exchange a few hundred Canadian dollars into Euros for your trip to France, you are essentially selling dollars and buying Euros. Alone it is nothing that would change the economy. But what if millions of people were doing that simultaneously?
It would mean that there would be upward pressure on the Euro, as many people want Euros (much like the Furby in the last post). The desire to own Furbies or Euos would cause the price to increase. At the same time, all those people selling Canadian dollars would cause its value to decrease.
Going back to our Japanese carry trade example from a few days ago, when interest rates in other countries were quite high compared to interest rates in Japan, many retail and institutional investors were sending money abroad: ie. they were selling yen and buying other currencies. The act of doing so meant that the Japanese yen remained low or went lower.
But then the world credit crisis and recession began and there were a few things that came into play in a very short time span.
- Japanese investors became fearful: Seeing the global problems many Japanese investors decided to get their money back to Japan as quickly as possible, so they sold their foreign investments and exchanged the money back into yen. This had the effect of strengthening the yen, as it was a sought after currency.
- Foreign stock prices fell: We all know the carnage that happened to global stock prices in late 2008 and early 2009. Many Japanese investors involved in the carry trade who had stock holdings sold their shares and repatriated their yen in order to avoid further losses. All this money coming back to Japan further strengthened the yen.
- Global interest rates began to drop: Investors who left their foreign investments in place began to question their decision as other governments lowered interest rates. If a Japanese investor had taken out a 1% loan to invest in a Canadian bank account that was now only making 0.25% interest instead of 4%, the investor was losing money. Many investors emptied their foreign bank accounts and brought money back to the “safety” of Japan. Again, increasing the value of the yen as so many people were selling other currencies and buying yen.
- Fear on Fear: Through it all, the yen was moving up in relation to many other currencies. A large portion of the movement was due to fear of further losses, or fear of a higher yen. As the yen kept moving up and up, many stragglers were forced to exchange their money back into yen for fear that the yen would go higher, and they would lose even more… ironically, in doing so they would have added to the demand for the yen.
And that brings us to today. Though the yen has come down some, it is still high because there are not many investors willing to take a chance on the global recovery yet. Once North America and Europe raise interest rates to more profitable levels, I think we will see the Japanese retail investor sending money abroad again, which should lower the yen’s value.
Though it’s taken me three posts, hopefully I’ve been able to answer the original question of what the carry trade is and why it moves the yen.