Yen carry trade: BoJ gives green light to short the JPY
10:43, 18 March 2022
The Bank of Japan (BoJ) has pretty much just given the green light for the carry trade with its continued monetary easing.
On Monday, Marc Chandler, chief market strategist at Bannockburn Global Forex, said: “With the US 10-year yield testing the 2% level and disappointing Japanese data underscored the risk of an economic contraction this quarter, the dollar rose above JPY117 for the first time in five years.”
He added: “The yen's weakness despite the risk-off is notable – it is trading more like a carry-play and less like a risk-off haven.”
The dollar's five-year high has now extended to JPY119 this morning.
As to where the yen will go from here, Marcel Thieliant, Senior Japan Economist at Capital Economics believes the Bank of Japan will keep policy loose even as inflation reaches 2% for the first time during BoJ Governor Haruhiko Kuroda’s tenure.
He pointed to Kuroda repeating the Bank’s usual mantra that “it won’t hesitate to take additional easing measures if needed” and insisting there “was absolutely no need for Japan to raise interest rates”.
“We agree and expect the Bank of Japan to keep both short-term and long-term interest rates unchanged for the foreseeable future. With the Fed [US Federal Reserve] poised to deliver a series of interest rate hikes and long-term US interest rates set to rise further, we expect the yen to weaken to JPY120 against the dollar by the end of this year and to JPY122 by end-2023, from JPY119 today”.
Carry trades
So why is this low interest environment significant for carry trades?
Essentially, a carry trade is a foreign exchange trade in which you borrow money in one currency at low interest and use it to make high-interest investments in another currency. You are using the leverage to maximise your profits. In a Japanese yen carry trade, the borrowing is in yen.
As an example of how it works, let’s assume a Japanese bank is offering loans at 1% interest a year.
You borrow ¥5,000,000 to make the carry trade, then exchange your ¥5,000,000 for $42,000 which you invest in US bonds that yield 5% a year.
This means you stand to make a profit of 4% a year after settling the debt.
Carry trades have advantages in that they can generate steady and improved returns. Additionally, if enough participants make the same carry trade, the returns can increase exponentially.
The more demand there is for a high-interest investment in a specific currency; the more valuable the currency and, hence, the investment becomes.
Yen carry trades have gained appeal because Japan’s interest rates have been consistently low for years.
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Dangers of carry trades
As with all types of trading there are inherent risks. Currencies are volatile and you can suffer big losses if the value of the currency you borrowed increases sharply or, alternatively, the currency you invested in falls in value.
If there are major currency swings, your returns could be much lower and the cost of exchanging money back to the currency you borrowed in to pay off your debt will be higher.
Because there may be substantial leverage used in the carry strategy, sharp adverse market movements may result in losses, leading to margin calls or the position being stopped automatically by the forex broker.
At the moment, the BoJ seems to be sticking to its low interest rate policy but what if there were unexpected interest rate moves? It might seem unlikely now, but unforeseen circumstances can dictate change, as too can new governments.
Foreign exchange intervention is a factor that can be detrimental to the carry strategy too. For instance, a central bank buys or sells foreign currency in an attempt to stabilise the exchange rate.
While Japan is a developed market, there is greater risk for carry traders in emerging market currencies which are typically more volatile in nature. And if one currency has a crisis, other markets might be affected too.
As a strategy, forex carry trading is easy to understand in that it leverages the differences in interest rates between countries.
One country’s central bank may lower interest rates in order to create economic stimulation (Japan), while the central bank in another country maintains higher interest rates (the US).
Now could be seen as the ideal market conditions for carry trading – but the danger is that these conditions don’t last as long as anticipated and FX traders take a hit. The principle ‘caveat emptor’ always applies.
But for now, it appears that the yen will remain under pressure against currencies such as the dollar and the pound which are supported by higher rates of interest. And while the yen is often seen as a safe haven currency, its appeal as such has been decreasing – even as Russia's war against Ukraine rages in Europe.
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