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The Never-Ending Story of the Yen Carry Trade

  • 8 mins read
dollar yen carry trade, forex trading

Once again, the Japanese yen is becoming a popular currency for carry trades. And why not? The 10-year bond yield difference between the US and Japan currently stands at over nearly 3%, which makes it the ideal trading condition for carry trade transactions.

So far this year, the yen has weakened against the US dollar by 27.23% as of early November! And there are no signs of a reversal in sight. 

So, in this article, we’ll look at the yen currency carry trade, what factors are involved, and whether the yen carry trade trend is likely to continue in the upcoming months.

First, What Is a Carry Trade?

Before we dig deeper, it’s important to understand what carry trade is. In simple terms, a carry trade includes borrowing or selling a low-interest-rate currency and then using it to acquire a higher-interest-rate currency. You earn more on the currency you acquired while paying a lesser interest rate on the currency you borrowed/sold.

So your profit is essentially the interest rate difference. You earn high-interest rates on your investments yet pay low-interest rates on your borrowings. For example, due to their low-interest rate policy, the Japanese yen and the Swiss franc are popular secondary currencies for positive carry trades.

Regarding high-yielding base currencies, popular ones are the Australian dollar and the US dollar. So, when you buy the USD/JPY, you will earn an annual interest rate of 3% without considering the currency pair’s price movement.

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Now, What Is a Yen Carry Trade?

A yen carry trade is when you sell Japanese yen at low-interest rates and buy USD or any other currency with high-interest rates. Technically, you borrow the Japanese yen and then swap your yen to buy high-interest currency like the USD.

Let’s give you an example.

Assume the Bank of Japan is issuing loans at 1% per year. So, you borrow 148500 yen from the bank. To complete the trade, you swap your ¥148500 for $1000, and then, you invest your dollars in 5%-yielding US bonds.

After paying off the loan, you will earn 4% annually. So if the USD/JPY pair will fall 4%, you will be in a break-even position. But if the USD appreciates versus the yen, you can make a higher annual return. That is, in a nutshell, the yen carry trade.

Yen Carry Trade: A Look-Back

Historically, the yen has been the most popular currency for carry trades, particularly since Japan’s lost decades started in 1991. Back then, Japan lowered its interest rates to stimulate the economy by reducing rates.

That was the catalyst for the depreciation in the yen’s value, and, ultimately, it helped the BOJ to increase the total value of its exports and Japan’s GDP. From that point, the Japanese yen has become the perfect candidate for funding carry trades. 

So, as you can assume, the yen carry trade has some interesting facts. Let’s break them down.

Yen Carry Trade Interesting Facts
  • Since the 1990s, Japan has maintained extremely low-interest rates. As a result, the yen has emerged as the preferred currency for the carry trade.
  • Carry trade between the yen and the US dollar was temporarily halted in 2008 due to the global financial crisis.
  • During the 2008 recession, the carry trade in the yen switched to high-yielding currencies such as the Brazilian real, Australian dollar, and Turkish lira.
  • The yen carry trade increased by 70% between 2010 and April 2013. Its worldwide FX trading stake has increased to 23% of the total.
  • Because Japan’s interest rates are so low, it has a combined total of $6 trillion in overseas assets. As they purchase foreign assets, the value of foreign currencies, such as the dollar, rises.
  • In 2019, the yen-dollar carry trade became more popular than before the pandemic. According to Commodity Futures Trading Commission statistics, net short posture in the yen was the most since January 2019.

Yen to USD Carry Trade – Why Is It So Popular?

Borrowing yen for US Dollars is the most common carry trade on the forex market. In contrast to Japan, the US Federal Reserve has kept interest rates “relatively” high over the years (with a break of nearly a decade following the 2008 financial crisis). As a result, a Yen-US Dollar carry trade offers the most profit potential.

It’s important to remember that trade is also profitable if the dollar is increasing versus the yen. If you borrow in yen and the dollar declines in value, you may lose money regardless of the interest rate differential, but only if the pair falls more than the interest rate differential.

Now, why is it happening? For nearly three decades, the conditions in the market stayed pretty much the same. Long-term obviously take advantage of using the rate differential to fund other investments.

But it is also crucial to keep in mind that the Japanese yen is the third most traded currency in the world and is perceived as a safe-haven currency when the stock markets drop drastically.

So, as you can see in the chart below, in times of economic growth and stability combined with wide rates differential – the yen carry trade makes a comeback every time. On the other hand, when there’s economic turmoil, the JPY usually strengthens drastically versus all currencies as it is widely viewed as a safe-haven asset.

dollar yen exchange rate historical chart
Dollar Yen Historical Exchange Rates

Japan’s lower-interest rates intend to generate a weak yen and a stronger dollar to reduce the cost of its exports. In 2016, Japan has also adopted the negative interest rates policy to fight deflation. It is also one of the most noteworthy holders of US debt, which is one of the reasons the US Treasury is so strong, resulting in low bond yields. Even when the Federal Reserve boosts short-term interest rates, it maintains long-term rates low.

In fact, you can use the USD/JPY pair to predict market risk. When markets are looking for risky trades, Treasury bond rates rise as the economy grows. Conversely, when the markets experience panic or anxiety, Treasury bond prices tend to climb, decreasing yields. In such a circumstance, the US dollar’s value may fall versus the yen, which is unsuitable for the carry trade.

USD/JPY Forecast – Will the Yen Keep Falling?

Historically, low interest-rate currencies underperform during periods of solid confidence and rising asset prices because investors are ready to take on greater risk. On the other hand, investors would flock to low interest-rate currencies during a financial crisis because they are seen as safe-haven assets.

So what about the yen carry trade now?

“In terms of pure FX carry, the dollar will soon provide 3%, the yen is still 0%, so that’s a big difference,” says Shusuke Yamada, chief forex and rates strategist at Bank of America in Tokyo.

Since this statement was given, rates in the US spiked to 3.75%, while the Japanese central bank has no intentions to raise rates in the near future. That has further increased the rate differentials, and as a result, the USD/JPY spiked to 150, the highest since 1997. Also, inflation rates in Japan are relatively low at 3%, which supports the continuation of the existing trend of the yen carry trade. 

So, under pressure from a Bank of Japan keen to keep local yields locked to the bottom even as interest rates worldwide rise, the yen appears to be the ideal well for carry traders to dip into.

The yen extended its worst losing run in at least a half-century this year. Speculators ignored official warnings about the currency’s collapse speed, concentrating on the increasing gap between Japanese and US interest rates. And as inflation bursts across most countries worldwide, central banks fight inflation with the only tool they have – raising interest rates.

Policy Rates of Major Central Banks

Currently, BOJ officials struggle to restrain currency movements, as the glaring contrast between the BOJ and Federal Reserve policies attracts a rush of bets on the yen sinking further. In September, The central bank of Japan intervened in the foreign exchange market for the first time since 199 to stop the falling yen.

While the policy distinction enhances its attractiveness as a carry trade currency, implied volatility acts as a counterbalance. Additionally, the concerns about an economic crisis in China could be another factor for the USD/JPY to fall drastically, as evident from the Chinese crisis in 2016. 

Still, according to most analysts’ and investment banks’ predictions, the USD/JPY could weaken even further. How further? According to Japan’s former vice minister of finance for international affairs, Eisuke Sakakibara, the pair could continue its free fall to 170 levels.

Furthermore, based on ING research, inflation rates in Japan are not expected to rise to 1% until 2023, which means that Japan is unlikely to see a significant rate hike anytime soon. If this is the case, the Japanese yen could continue its depreciation rally in the upcoming years, and the yen carry trade is still on

As economic recovery takes hold and more central banks raise their rates, the interest differentials between their currencies and the yen may begin to widen to attractive levels yet again. We may see yen carry trade resurfacing.

MIDF Research

Final Thoughts

Carry trades, and particularly yen carry trades, are popular and rewarding. As long as market conditions stay the same, it seems that the yen free fall is likely to continue. However, you should proceed with caution and consider other factors when implementing the USD/JPY carry trade strategy.

For example, you must pay attention to the stock markets and the reverse currency war phenomenon. Remember, the value of currency rates is fundamentally variable, so you can quickly suffer losses if things go wrong. And that is especially the case for the yen, which tends to react strongly when appreciating versus other currencies. 

That is why it’s critical to think about the long term when using the carry trade strategy. It’s not only about where interest rates are today but also about where they’re headed. 

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