Most of the commentary surrounding the dual Dollar-Yen rally that has unfolded over the last couple months has focused around monetary policy and risk aversion. Accordingly, the prevailing theory is that both currencies are being driven upwards because of narrowing interest rate differentials and a collapse in
risk tolerance.
However, it's also important to consider the role of
technical/financial factors. Specifically, liquidity in foreign exchange markets is dissipating rapidly as market participants have found it difficult to secure lines of credit to finance leveraged currency trades. In addition, those with leveraged short positions in the Dollar and Yen have been forced to partially unwind their positions for the same reason. In hindsight, the decline in both the
Dollar and the Yen over the last few years now appears to have been driven primarily by the same expansion in credit that underlied the real estate bubble, which enabled traders to take advantage of interest rate differentials to earn relatively risk-free profits from a carry trade strategy.
Regardless of the fact that these interest rate differentials persist and a carry trade strategy remains theoretically viable, it's becoming impossible to undertake because of a shortage of credit and liquidity. FX Solutions reports:The credit crash has affected participation rates in all markets. Many speculative players who depended on credit and
leverage to fuel their trading have withdrawn. They will not return anytime soon.
