* Recent yen rise hits demand for emerging market assets
* Volatility jumps as Fed seen withdrawing stimulus
* Large outflows from Japanese investors yet to materialise
By Sujata Rao
LONDON, June 18 Wild exchange rate swings in the yen are giving investors an added incentive to sell holdings of the emerging debt that not so long ago was billed as one of the prime beneficiaries of Japan's money-printing drive.
For an asset class that is already under pressure from higher U.S. bond yields, this is bearish. For carry trade investors - those who borrow a low interest rate currency, in this case the yen, to invest in a higher-yield foreign asset - sudden strengthening can wipe out gains almost overnight.
For example, an investor who sold yen to buy emerging debt when the Japanese currency was at a record low 103.74 per dollar on May 22 would have suffered a loss of about 9 percent because of the yen's subsequent reversal.
Those who sold yen for the South African rand or Mexican peso would have fared even worse, as the yen firmed around 10 percent or more against these currencies.
After plumbing four-year lows in May, the yen has surged almost to levels recorded before the Bank of Japan's April 4 announcement of major stimulus. At least in the near term, this is eroding expectations a weak yen will drive a flood of Japanese funds into higher-yield emerging market investments.
"A lot of Japanese investors who might have been thinking of moving into emerging markets will be having second thoughts now," said Manik Narain, emerging markets strategist at UBS.
The yen and rising yields on Japanese bonds add another layer of worry for emerging domestic debt where a possible end to U.S. stimulus has driven average yields almost one percentage point higher since early May while currencies have fallen to multi-month lows.
Uncertainty over the Fed's stimulus withdrawal as well as doubts over the effectiveness of Japan's reflationary policies has led to a volatility spike in world financial markets - an environment in which the yen typically tends to strengthen.
"If you are a carry trader you want low volatility but the opposite is happening. Rising volatility in U.S. Treasuries and the yen are going to be a key barometer for EM," Narain said.
Derivatives markets point to more pain ahead.
One-month implied volatility on the dollar-yen exchange rate has jumped to two-year highs while volatilities on Japanese bond futures have also spiked
And three-month risk reversals, a gauge of relative demand for put or call options - which the right to sell and buy, respectively - are flipping towards yen calls, or bets the currency would gain.
No wonder short yen positions have also fallen to less than $10 billion, according to the U.S. Commodity Futures Trading Commission, down from more than $13 billion two weeks ago.
It was probably no coincidence that hardest hit in last week's rout were markets such as Mexico and Turkey which have been popular with Japanese investors. Overall, since the start of June around $1.3 billion has fled local bond funds.
But the reversal was possibly less painful for Japan's investors than for outsiders. Billions of dollars had flocked to emerging debt in anticipation of gains fuelled by yield-seeking Japanese, who hold over $17 trillion just in household savings.
But Japanese flows have underwhelmed, with total assets of Japanese EM-oriented toshin, or investment trusts, actually down slightly this year to around $58 billion, JPMorgan data shows.
In fact Japan-domiciled funds with over $52 billion in assets pulled over $700 million from emerging debt in April and May, according to data from Lipper.
"There was an expectation there would be huge capital outflows (from Japan), you saw hedge funds position themselves in emerging markets in anticipation of these flows," said Philip Poole, head of global strategy at HSBC Global Asset Management.
"When those outflows failed to come and given the tapering concerns that have come through in the meantime, those positions from the hedge fund community..were liquidated, We've seen a pretty sharp impact on EM bond markets because of that."
So how long will this setback last? Several factors are at play. One, much will depend on the timing and pace of the Fed liquidity pullback-- emerging markets cannot in the short-term withstand a rising dollar and higher U.S. yields.
On the other hand, the BOJ will continue to pump yen and many reckon its drive will leave Japanese with no option but to take their yen elsewhere -- HSBC for instance predicts $600 billion in outflow over the next 18 months.
Most of this will however be channelled to European and U.S. markets -- UBS estimates that emerging markets received less than a tenth of the $850 billion that Japanese investors have poured into world markets since 2005.
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