In early August, the global financial landscape was rocked by the resurgence of a strategy known as "yen carry trade". This approach, which had substantially gained traction this year, led to a severe market turmoil due to unwinding positions that adversely affected global stock markets. This particular investment strategy involves borrowing in a currency with low interest rates and investing in assets that yield higher returns elsewhere. Currently, the disparity in yields between Japanese and US Treasury markets remains significant, coupled with relatively low volatility, which continues to attract speculative interests and leverage-based hedge funds back into this low-cost currency trading tactic.
However, this revival comes at a critical juncture as the Bank of Japan (BoJ) appears poised to announce a potential rate hike in December, introducing concerns among market participants about the re-emergence of what could be termed a "nightmare scenario" of unwinding carry trades. This apprehension follows the turmoil inflicted on the global financial markets just a few months prior, specifically due to the unwinding of these trades which had led to catastrophic declines in stock prices worldwide.
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Recent analyses from institutions such as the Japan Financial Futures Association and the Tokyo Financial Exchange predict a significant increase in bearish yen bets, with expectations for November's figures soaring from October’s considerable $9.74 billion to over $13.5 billion. The growing anticipation of further bearish positioning is primarily tied to the stark differences in baseline interest rates and bond yields between Japan and the United States, alongside heightened US government borrowing, and persistently low foreign exchange market volatility.
Indeed, the carry trade has attracted hedge funds and retail investors alike, with net short positions on the yen reportedly increasing again, indicative of a speculative trend pouring investments back into yen carry trades. Alvin Tan, who heads Asia Foreign Exchange Strategy at the Royal Bank of Canada in Singapore, noted, “The absolute yield differential compared to most currencies is enormous, which means that the yen will always be viewed as a funding currency for trades.” He further explained that sovereign currencies not typically used for carry trades would have lower volatility and smaller yield differentials, which makes the yen particularly appealing for such activities.
As this situation unfolds, a sense of deja vu haunts the financial markets. Strategies heavily reliant on yen trades are now facing the familiar specter of risk as whispers of rising interest rates circulate among traders. Some analysts from Mizuho Securities and Saxo Bank argue that the scale of yen carry trades might revert to the levels observed from late July to early August, just before the Bank of Japan surprised everyone with their own rate hike and a hawkish shift in policy, coinciding with weakening US job figures that fueled recession fears.
This investment method could substantially sway global stock markets, much like the selloff experienced this past summer, which erased a staggering $6.4 trillion in global stock value within merely three weeks. Notably, Japan’s benchmark Nikkei 225 index witnessed its largest drop since 1987 amid this volatility, raising alarms among investors globally and highlighting just how significant these trades are.
Recent fluctuations in yen valuations have reignited investor interest, especially with substantial US non-farm data set for release this week, alongside imminent monetary policy decisions from the Bank of Japan just a fortnight away. The renewed surge in expectations surrounding a potential December interest rate hike has created an environment reminiscent of the lead-up to the problematic selloff witnessed in August.
Earlier this month, Bank of Japan Governor Kazuo Ueda emphasized the importance of considering wage levels and other factors pertinent to price stability while contemplating the timing of potential interest rate hikes. Recent economic reports, particularly regarding inflation rates in Tokyo, have indicated a quicker-than-anticipated rise, reinforcing the narrative of a resilient economy that is edging closer to the BoJ adopting a more aggressive monetary stance.
The episode of widespread unwinding of carry trades in August can largely be attributed to an acceleration in the yen’s appreciation, prompting a hurried exit among traders. The prevailing wisdom was that a rate hike could undermine Japan’s fragile economic recovery while simultaneously weighing heavy on major exporters like Toyota. As the yen surged, the risk associated with these trades amplified, underscoring how sensitive the strategy is to currency fluctuations. Any substantial appreciation in the yen means that traders, who typically borrow in yen, have to repurchase at higher prices to settle their obligations, often forcing them to liquidate positions in other liquid, riskier assets, including stocks, to cover losses.
The key factors behind yen carry trades remain focused on the significant interest rate and bond yield differentials on offer. Average bond yields for top-performing currencies often exceed 6%, whereas, due to the BoJ’s current rate being merely 0.25%, the resultant yield for those participating in yen-based trades is nearly negligible, cementing the yen's role in these strategies.
Despite the backdrop of impending rate changes, speculation continues with traders eager to reignite the yen carry trade wave. Even as the Bank of Japan gradually hikes interest rates, gaps between yields in Japan and other major economies remain robust. With the US Federal Reserve’s baseline rate recently trimmed to a range of 4.5%-4.75%, it is still far exceeding Japan’s rate. Australian and New Zealand Banking's Forex analyst Felix Ryan notes that even if Japan’s rates hovered around 1%, the allure of these trades wouldn’t diminish.
This lucrative strategy of borrowing in yen has generated substantial profits for leverage-based hedge funds over the recent years. Data illustrates a staggering 45% accumulated returns from yen funding transactions targeting ten primary and emerging market currencies since late 2021, vastly outpacing the S&P 500's approximately 32%, inclusive of reinvestment dividends. Such phenomenal results have lured an increasing number of funds, resulting in unrealized short positions on the yen peaking at a remarkable $21.6 billion right before the foreign exchange market faced its unwinding wave.
Nonetheless, some analysts caution about the sustainability of yen carry trades moving forward. With the growing likelihood of narrowing interest differentials, particularly following the softened stance from BoJ officials like Governor Ueda regarding December rates, there is an emerging consensus that the momentum for these strategies may slow. Additionally, the Japanese finance ministry has voiced concerns over significant unilateral volatility observed in the yen’s trading patterns lately.
This year, the yen has underperformed compared to most G10 sovereign currencies amidst significant capital outflows and persistent yield disparities. Although its value surged to roughly 140 yen per dollar following earlier trade liquidations, it has since receded to around 150. Jane Foley, head of forex strategy at Rabobank, remarks on this dynamic, indicating that Japanese officials are probing avenues to engage with traders through verbal interventions while concurrently reflecting on hawkish signals from Ueda, which has subsequently sustained speculation about possible December adjustments.
As the clock counts down to pivotal monetary policy meetings slated for December involving both the BoJ and the Federal Reserve, investors are likely to gain clearer insight into the future of yen carry trades. Should Ueda's rhetoric soften or if Federal Reserve Chairman Jerome Powell articulates a more hawkish stance, combined with key data points such as US non-farm employment figures and unemployment rates, it could trigger a massive influx back into these risky trades.
If indications suggest that rate hikes may proceed at a slower pace in Japan and signs emerge that Powell does not anticipate immediate rate cuts, the attractiveness of the yield differentials could massively favor the carry trade once again. Investors are heavily weighing these possibilities, especially if the Japanese finance ministry adopts a more restrained approach, as any wait-and-see attitude could prompt further engagement in low-cost strategies designed for profit.
