House buyers in eastern Europe have recently developed a taste for exotic home finance. Bankers say a significant slice of new mortgages in Hungary are being issued in Swiss francs. Meanwhile, households in Latvia and Romania have developed so much enthusiasm for borrowing in yen that the trend has provoked surprise - and unease - from central bankers half a world away in Tokyo.
The obvious attraction is the interest rate. Switzerland and Japan have among the lowest money market rates worldwide, giving investors a discount on their mortgages worth as much as 5 percentage points a year.
Home buyers may not be aware that in taking out such an attractive loan they are becoming global "carry traders", rubbing shoulders with hedge fund managers and bond dealers who have made tremendous profits borrowing in currencies where interest rates are low and investing in those where they are high.
But life for a carry trader is becoming increasingly fraught with risk, exposed to everything from Japanese inflation to the course of the New Zealand dollar, not to mention that Latvian mortgage market. If the yen or the Swiss franc rallied suddenly, if US interest rates fell, or any number of arcane and impossible to predict events occurred somewhere in the world, the carry trade - which is estimated to be operating at unprecedented volumes - could unwind, with drastic consequences.
That could then spark a huge rally in the yen or Swiss franc, leaving everyone who borrowed cheaply in these currencies owing far more than they had bargained for and potentiallyfacing hefty losses on their investments.
But right now, at least, many countries - and investors - appear to be reaping benefits from this practice. To take one out-of-the-way corner of global finance, the amount of bonds denominated in New Zealand dollars by European and Asian issuers has almost quadrupled in the past couple of years to record highs. This NZ$55bn (US$38bn, ?19bn, €29bn) mountain of so-called "eurokiwi" and "uridashi" bonds towers over the country's NZ$39bn gross domestic product - a pattern that is unusual in global markets.
The reason is not hard to find: during recent years, New Zealand's interest rates have been some of the highest in the industrialised world, at around 7 per cent. The difference between this and yen interest rates of 0.25 per cent means large profits for carry traders, which include both Japanese households and global hedge funds.
The fact that investors are buying New Zealand-denominated bonds has kept the value of its currency relatively stable in recent years - even though the country has a large current account deficit, which would normally cause foreign exchange jitters. Conversely, because investors are selling yen assets, Japanese exporters enjoy the benefits of a weakening currency. Indeed, on a trade-weighted basis, the yen is at a 21-year low.
In the global financial markets as a whole, the carry trade has been a key factor behind the high levels of liquidity that have enabled investors around the world to purchase assets ranging from simple equities to emerging market instruments and complex credit products.
The problem is that activity involving the carry trade has recently become so feverish that it is creating some striking distortions in the financial system - of which the New Zealand bond eruption is just one. While it is fiendishly difficult to track the precise scale of activity - since much of this trading takes place in private markets - fears are growing that if investors suddenly decide to unwind this carry trade for any reason, the reverberations could be painful.
After all, the last time carry trades built up in this way in the financial system, back in 1997 and early 1998, they later unwound in a dramatic fashion after the Russian financial crisis of mid-1998. That pushed the yen up by nearly one-quarter against the dollar in a few weeks - eventually contributing to the implosion of Long Term Capital Management, the US hedge fund.
This historical parallel has already made some observers uneasy about the risks besetting New Zealand. "If investors turn bearish on carry trades, then the New Zealand dollar will clearly crack," warn people such as Mansoor Mohi-Uddin, chief foreign exchange strategist at UBS, who estimates that foreigners own nearly 70 per cent of New Zealand government bonds - up from about half in 2003.
All this could have implications for global markets too. At last weekend's meeting of leaders of the Group of Seven industrialised nations in Germany, finance ministers warned traders that they needed to take account of the "risks" of a Japanese recovery - an oblique warning against an excessive use of the carry trade.
"Regulators are increasingly expressing their concern that the very high level of speculation in the so-called yen carry trade has the potential to produce widespread financial market instability and, in extremis, systemic risk," says Albert Edwards, analyst at Dresdner Kleinwort. Or as Hans Redeker, head of currency strategy at BNP Paribas, adds: "Now, as in 1997, low-yielding currencies have been used as the global cash machine, pushing liquidity into asset markets. In 1997 the Asian crisis markedthe end of this development.This year we suggest that emerging market assets and equity markets could set the turning point, sparking carry tradeliquidation."
Traders are divided about just how large the danger of this scenario really is - not least because it is impossible to measure exactly how the carry trade is being used and, thus, which investors are running the largest risks. As the yen and Swiss franc are the most popular currencies for finding cheap loans, however, some clues to activity can be gleaned by watching the bets that investors make about the future direction of currencies.
The Chicago Mercantile Exchange, for example, produces data showing how investors are positioned in their currency bets. This reveals that the market is betting on future yen and Swiss franc weakness to a record degree - while also assuming that currencies such as the Australian dollar and the pound sterling will rise. A separate estimate by Barclays Capital, which compares yen and Swiss franc borrowing to activity in the Australian and New Zealand dollars, suggests that the trade is now more lopsided than at any point since 1998.
"The magnitude of Japan-funded carry is reaching scary levels, in our opinion," Barclays says, adding that "even if the macro environment remains benign for carry trades, we cannot rule out the possibility of a sudden unwinding of positions that simply feeds on itself." More specifically, as investors take bigger bets, some may be so overstretched that they will be forced to exit their positions at the first sign of any jolt - simply because they cannot afford losses.
Moreover, there are plenty of factors that might conceivably produce market jolts. If the Japanese central bank started to raise interest rates, this could undermine some investor enthusiasm for carry trades. Similarly, if the yen rallied suddenly, that could reduce profits from the carry trade - which might force investors to cut their positions (such as a "short" bet on the yen, which assumed the yen would weaken). That could in effect prompt the yen to rise even further - creating a vicious circle, of the sort that developed in 1998.
While the yen has traded only in a narrow band in recent weeks, some political voices are now pressing for it to rise. Politicians in France, for example, want currency readjustment because European manufacturers that compete directly with Japanese rivals are losing ground.
Policy mistakes by central banks could also trigger a rise in volatility, which would undermine the logic of the carry trade: UBS, for example, warns that if investors fear that the US Federal Reserve has become lax in fighting inflation, risk aversion will rise - as it did back in 1998.
What no one knows, however, is when an unwinding might happen or how dangerous it might be. Despite the dangers lurking under the surface, the current logic of global markets means that borrowing in this manner is still profitable - and thus too tempting for some investors to ignore.
"It is true that a rise in volatility could make carry trades significantly less attractive," says JPMorgan. "But at the moment we do not envisage sources of macroeconomic surprise . . . which could create a sustained upward move in market volatility in the next few months."
After all, as optimists point out, the gap between borrowing costs in Japan and countries such as New Zealand is so large that it will not be erased by one or two rate movements.
Moreover, it is far from clear that pressures for a sustained rise in the yen are really in place: economic data from Japan remain patchy and most policy-makers are reluctant to trigger a rapid readjustment of exchange rates right now. Last week's G7 meeting, for example, gave no hint that global monetary policy chiefs will intervene in currency markets to strengthen the yen.
Another important factor exists that might reduce the chance of an imminent explosion: the use of hedging strategies. In recent years, the level of volatility in global currency markets has been low. So it has been cheap for investors to buy derivatives that protect them from a sudden swing in the yen (in much the same way that the cost of home insurance falls in areas where burglaries have declined).
This has apparently prompted many hedge funds to use a twin-track strategy: they have been borrowing in yen to fund their global investments, knowing they will profit if the yen weakens, but they have also bought protection against any Japanese currency rebound.
That might lessen the chance of a storm erupting if the carry trade unwinds. After all, what made the 1998 turmoil particularly vicious was that when the yen started to rally, it inflicted such pain on the hedge funds that they were forced to unwind their carry trades - triggering further yen rises.
"People are much better placed now than they were back in 1998," says the European head of a global investment bank. "They learnt lessons."
Copyright The Financial Times Limited 2007