Title: The Yen’s Quiet Revival in Global Carry Trades
By Loukas Christodoulou (original article on Finextra.com)
As global markets navigate the possibility of shifting interest rate cycles, one currency is quietly stepping back into a familiar role in the world of foreign exchange trading: the Japanese yen. Traditionally considered a favored funding currency for the popular carry trade strategy, the yen’s appeal has waxed and waned over recent decades. However, recent developments suggest that the yen may be regaining its standing as a key currency in carry trades.
Carry trading involves borrowing in a low-yielding currency to invest in a higher-yielding asset, profiting from the interest rate differential. The strategy is often used in foreign exchange markets when interest rates in one major economy remain much lower than those in others. The yen has historically been central to this strategy due to the Bank of Japan’s (BOJ) long-standing policy of ultra-low interest rates. But with global monetary policy in flux and Japan’s yield curve control under review, market participants must reconsider how macroeconomic shifts reinvigorate the carry trade, and where the yen fits into this evolving landscape.
Understanding the Carry Trade
To contextualize the yen’s role, it’s essential to understand how carry trades function:
– Investors borrow funds in a currency with a low interest rate (such as the yen).
– These funds are then used to invest in assets denominated in currencies with higher interest rates (such as the Brazilian real or South African rand).
– The goal is to profit from the interest rate differential, assuming exchange rates remain relatively stable.
This strategy is appealing during periods of low volatility and minimal exchange rate fluctuations. However, during times of increased financial uncertainty or shifting monetary policy, carry trades can unwind quickly, leading to sharp movements in currency values.
The Return of the Yen to the Carry Trade Spotlight
Over the past year, certain macro and policy developments have repositioned the yen as a potential funding currency favorite once again:
– The BOJ has remained steadfast in maintaining negative interest rates and yield curve control, even as other central banks engage in tightening monetary policy.
– The Federal Reserve, the European Central Bank, and other central banks have hiked interest rates aggressively since 2021 to curb inflation, creating substantial interest rate spreads versus the yen.
– Japan’s inflation, while rising slightly, remains significantly lower than that of other developed economies, enabling the BOJ to justify its dovish stance for longer.
The key catalyst reigniting interest in yen-funded carry trades is the widening interest rate differentials. As rates in the US, Europe, and emerging markets climb and Japan remains in an ultra-accommodative policy mode, the yen becomes an ideal funding currency.
Assessing the Drivers of Yen Weakness
Currency traders have increasingly shorted the yen throughout 2023 and into 2024. Several factors underpin this trend:
– Ultra-low yields: Japan’s benchmark interest rate remains deeply negative compared to other Group of Seven nations.
– Dovish central bank policy: The BOJ, under the leadership of Governor Kazuo Ueda, continues supporting accommodative monetary measures.
– Low inflation: Japan’s inflation has picked up moderately but is still tame relative to surging prices in the US and Europe.
– Capital outflows: As Japanese investors seek higher returns abroad, demand for foreign assets has pushed the yen lower.
This combination has led to renewed short interest in the yen, particularly against currencies with more hawkish monetary policies. Currency pairs like USD/JPY, EUR/JPY, and even AUD/JPY have seen increased carry trade activity as traders exploit the interest rate gaps.
Comparing Yen Carry Trade Performance
The performance of classic yen carry trades tells the story. Since 2022, several crosses involving emerging market and commodity-linked currencies have delivered strong positive returns when funded in yen.
Examples include:
– BRL/JPY (Brazilian real vs yen): Gained due to Brazil’s high central bank rates compared to
Explore this further here: USD/JPY trading.