Be very afraid if carry trade unwinds fast, says funds manager

By NZPA

Monday 19th March 2007

A rapid unwinding of currency carry trades could leave the Reserve Bank unable to lower interest rates, even in the property market slowed in response to high mortgage rates, a leading funds manager is warning.

Carry trades involve investors borrowing low interest currencies, such as the yen, to invest in higher yielding assets, such as the New Zealand dollar.

Arcus Investment Management chief investment officer Mark Brighouse said a preview of what could happen was provided last month when investors who had borrowed yen to invest in this country's high interest rate took fright at a wobble in the Shanghai sharemarket and sought to exit.

That led to a sharp fall in the New Zealand dollar.

"A sharp decline in the currency from a further rapid unwinding of yen carry trades would add to New Zealand's inflation risk," Mr Brighouse said.

That would prevent the Reserve Bank from cutting interest rates even if the housing market slowed in response to high mortgage interest rates.

"The yen carry trade, if it unwinds in a rapid fashion we need to be very afraid because that could cause a lot of instability," he said.

"It will however accelerate the rebalancing of the New Zealand economy. It's just that when you try to rebalance something quickly it can be pretty bumpy."

Arcus said a reasonably rapid decline in the NZ dollar, which had been overvalued for some time, could happen as fundamentals came back into focus and a key source of currency support disappeared.

The risk to the carry trades came as cracks might be starting to emerge in the economy after consumer confidence had stayed high in 2006.

Households and companies were now both under pressure.

Companies were being squeezed by rising costs, and an inability to push prices up fast enough to protect profit margins and a drop in volumes.

Pressure on households was revealed by an "alarming" rise in the number of personal bankruptcies, Arcus said.

A combination of higher debt levels and higher interest rates had taken debt servicing costs to a record 13 percent of disposable incomes.

"With domestic interest rates expected to remain at current high levels for most of this year and possibly into 2008, the economy is expected to struggle to regain momentum," Mr Brighouse said.

"While recession is likely to be avoided the potential for earnings disappointment and sharemarket underperformance is likely to remain."

With a crisis now under way in the US subprime mortgage sector, which serves borrowers with poor credit histories at high interest rates, Mr Brighouse said he expected all the economies boosted by easy credit in recent years to have difficulties related to debt servicing.

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