Slower path of rate changes should ease yen carry trade fears
The yen carry trade has garnered much attention since the summer when the Bank of Japan’s surprise rate rise triggered volatility across financial markets. This was shortlived, but the episode still wiped 12 per cent from the Nikkei in one day and hit stock and bond markets around the world.
The trigger for the calamity has been put down to the rapid unwinding of the yen carry trade, driven by faster rate rises in Japan and loosening in the US. The convergence of interest rates makes borrowing in yen to invest in dollars less attractive.
As the BoJ prepares to raise rates either next week or in January, the possibility of a repeat episode is a key concern for policymakers. As the moment approaches it is then worth looking at what we have learned since the summer to inform what will happen next.
The carry trade explained
In essence, any carry trade is just one that exploits interest rate differentials with borrowing in low yielding currencies and investment in higher yielding ones.
Given that Japan has embraced ultra-low interest rates for almost three decades it is the natural place to carry from. Borrowing at short-term rates close to zero to invest in short-term dollar assets with rates close to 5 per cent is very profitable, so long as exchange rates do not move adversely.
The carry trade that is concerning officials since the summer is exactly this leveraged trade between the yen and the dollar. These are funds that borrow in yen, which they then sell in spot currency markets to buy assets in higher yielding denominations like the dollar.
We know there is a correlation between real interest rate differentials in yen and US dollar terms and the yen dollar exchange rate. As the real interest rate available in yen fell sharply compared with that in dollars since 2022, the yen has also weakened. Causality in this relationship, however, is harder to pin down.
But the correlation itself is a concern for the BoJ and Japan’s politicians because the weak yen is pushing up prices for consumers of basic goods like food and energy which Japan imports. This has put pressure on the BoJ to increase nominal rates.
How big is the carry trade?
The simple answer and, what makes the topic contentious, is that no one really knows. There are proxy indicators such as bank lending that all point to growth in this type of trading and investment, but it is notoriously circumstantial.
Cross border bank lending has soared in recent years. Yen borrowing rose from about ¥200tn at the start of 2020 to ¥315tn ($2.1tn) in the middle of this year, a 50 per cent increase in yen terms, according to BIS data.
Much of that has been originated by banks outside Japan, notes Shrikant Kale at Jefferies. Yen funding to foreigners almost doubled between 2022 and this year to about ¥40tn ($266bn). The true value of on-balance sheet speculative carry trade positions is probably somewhere between those two figures.
The off-balance sheet element of the carry trade, however, is potentially a greater concern and documented with even less precision. “The notional value of outstanding FX swaps, forwards and currency swaps with the yen on one side has grown to $14.2 trillion (¥1,994 trillion) by end-2023, up 27% in yen terms since end-2021” the BIS said in recent research trying to estimate the size of these exposures. It put the amount of this dedicated to speculative hedge fund positions at $160bn.
An alternative measure using the difference between on-balance sheet and off-balance sheet FX exposures at banks yields a number that increases by about $400bn between 2021 and today at fixed exchange rates.
The preference for derivatives was probably reflected in the large net short position in yen futures observed around the summer crisis, which was at record levels not seen since the global financial crisis.
What was different about what happened in the summer and 2007 was the speed of the unwinding. The yen appreciated about 8 per cent in a matter of days in August this year. The same movement, a function of yen buying as carry trade positions closed, took weeks to manifest back in 2007.
The speed of the carry trade unwind was at least in part down to the large equity component that was probably involved this time around. We do not know how much of the yen borrowing has flowed into US equity positions but the large falls in tech stocks that corresponded with yen appreciation in August suggests it was significant. This hypothesis will be tested when the BoJ decides to raise rates next.
What will happen?
The BoJ is trying to reassure investors. governor Kazuo Ueda said in November he “does not think there is a huge build-up of yen carry positions either way, compared with the situation in July.” That may only mean the exposure today is no larger than back then.
There are other reasons to be positive. A recent rally in the yen, which has strengthened by about 3 per cent since the middle of November, may be a sign that a pre-emptive and precautionary unwinding of more speculative carry trades is under way given that markets are pricing a 75 per cent chance that the BoJ holds rates on December 19.
The speculative short position in yen futures, while still net short, is also smaller today than it was in the summer. The “carry-to-risk ratio” which includes currency volatility in its calculation has also become less favourable for the yen since the summer, notes Daiwa Securities. This suggest the appetite for riskier derivative based bets and another rapid unwinding are both now smaller.
There are also fundamentals to consider. The BoJ has committed to a less hawkish and shallower path of rate adjustment since the summer even though it believes it has created a welcome wage price dynamic within the Japanese economy. The Fed, meanwhile, has been forced into a less dovish position by the strength of the US economy, residual inflation and coming policy changes under president-elect Donald Trump.
That should give investors confidence that the interest rate differential will remain wider for longer than appeared likely in the summer and facilitate a slower unwinding of longer-term carry positions. Given the broader implications for financial stability it also means that the BoJ is likely to be a lot more careful in its messaging before going ahead with a rise.
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