The big bet that could melt Wall Street

NEW YORK (CNNMoney.com) -- As investors wonder if the global market selloff is reaching a bottom, economists are keeping a close eye on one big trading bet that could send more seismic tremors through Wall Street.

For more than a decade, investors have profited by borrowing yen at ultra-low interest rates and using the funds to buy higher-yielding investments based in other currencies - known in Wall Street parlance as the yen carry trade.

But last week's market swoon has brought risk back into focus, and a number of these borrowers have been unwinding those trades lately.

"There's been complacency and under pricing of risk across the board," said Nouriel Roubini, chairman of Roubini Global Economics, a research firm. But now many big investors, as well as policy-makers, are bracing for more volatility in the markets, he said.

While the yen carry trade grew popular after Japan started holding interest rates steady near zero six years ago, it's only recently that a variety of hedge funds, insurance companies and mutual funds are getting out of those bets - and removing a key source of support for stocks.

In the process they've sparked a swift rise in the yen - which has jumped 4 percent against the dollar in the last week alone - as they've bought yen to repay their loans.

While it's difficult to quantify the size of the yen carry trade, investors have borrowed yen aggressively to fund a wide range of investments - from riskier assets in emerging markets to safer investments like U.S. Treasury bonds, economists said.

They're divided, though, on whether the yen's recent rise is a short-term run or the start of a massive unraveling of yen-based trades that could roil financial markets further.

"It's a little shake-out. A few people scared out of the yen carry trade may have pushed the currency up, but it doesn't mean the yen carry trade has changed fundamentally," said Robert Brusca, chief economist of FAO Economics.

Interest rates in Japan are still super-low relative to rates in the United States and Europe. Japan's benchmark short-term interest rate stands at 0.5 percent, compared to 5.25 percent in the United States and 3.5 percent across most of Europe.

The Bank of Japan brought an end last July to its ultra-easy monetary policy by raising rates for the first time since 2000. But its rate hikes haven't been consistent and the central bank isn't expected to aggressively raise rates anytime soon.

Howard Simons, a strategist at Bianco Research in Chicago, thinks given how low Japanese rates are versus the rest of the world, the yen carry trade still has a long way to go in any unwinding.

And "the unwind, if it starts to occur - is not going to be a one-week occurrence. It's going to occur over a long period," he noted.

Others see the yen's recent spike as the start of a real unraveling of the carry trade. "By all appearances, this is the real thing," said Patrick Fearon, economist with A.G. Edwards & Sons.

While the spread between interest rates in Japan and elsewhere around the world remains wide, investors are realizing now that the yen can move much more quickly even if the central bank doesn't raise rates very quickly - thereby destroying the profitability of the carry trade, Fearon said.

"Even if the Bank of Japan holds rates steady - as it is widely expected to do - a rise in the yen itself could spark a self-sustaining unwinding of the carry trade," he added.

And suddenly - since last week's 416 point drop for the Dow - investors have woken up to the risk inherent in financial markets.

When markets are more volatile, expect big gains and big losses to come hard and fast, Roubini said, referencing the yen's abrupt movements during the Asian financial crisis, when the yen jumped as much as 12 percent during one 72-hour period in 1998.

"This is not a risky trade I would continue if I was an investor. Any trigger can cause a sudden movement at this point," Roubini said.

Subprime woes: How far, how wide

More on the markets

More on investing

CNNMoney.com's new portfolio tool

Currency converter and latest rates