Carry trades in play

THE yen’s latest slide is putting the carry trade back in the spotlight, with investors once again looking beyond Japan’s currency intervention and towards the wide interest-rate gap that makes borrowing yen so attractive.

But as traders rebuild bets against the Japanese currency, the strategy is becoming a bigger gamble, particularly as Tokyo and Washington have shown they are willing to step into the foreign-exchange (forex) market to support the yen.

According to Bloomberg and Reuters reports, the recent US-Japan intervention has done little to change the underlying forces weighing on the yen.

Instead, the brief rebound has given some investors an opportunity to reload positions betting on further weakness.

The basic mechanics of the carry trade remain straightforward. Investors borrow in a currency with low interest rates, such as the yen, and use the proceeds to buy assets denominated in currencies offering higher returns.

As long as the funding currency remains weak or stable, investors can pocket the interest-rate differential while also potentially benefiting from currency movements.

Japan’s policy rate is currently just 1%, well below rates in many developed economies.

That leaves the yen as one of the world’s most attractive funding currencies, despite the growing risk that Japanese authorities intervene to prevent excessive weakness.

Bloomberg reports that hedge funds had halved their bearish yen positions through Aug 4, but some investors were already returning to carry trades funded by the currency, citing market watchers including JPMorgan Private Bank and State Street Bank & Trust.

Among them is Ashwin Binwani, founder of private investment firm Alpha Binwani Capital, who bought the dollar against the yen at around 157.

“Intervention is a great opportunity to sell the yen at higher levels,” Binwani is quoted as saying by Bloomberg.

“We are not daunted by their actions. The carry trade is too good to miss,” he adds.

The problem for carry traders is that the very success of the strategy can invite the authorities to act again. As investors rebuild short-yen positions, they increase the pressure on the currency – and potentially the political incentive for Tokyo to intervene.

Costly intervention

Bloomberg says Japan likely spent around US$34bil intervening in the currency market on July 31, according to its analysis of central bank accounts.

That followed an estimated US$53bil intervention the previous day, which would be the largest single-day operation on record if confirmed.

The United States has also thrown its weight behind efforts to stabilise the yen. Treasury Secretary Scott Bessent has reiterated US support for Japan, saying yen weakness risks broader depreciation across Asia, while Washington will do “whatever it takes” to support Japan.

Yet, the interest-rate differential remains difficult to overcome.

Bloomberg reports that shorting the yen against the higher- yielding Colombian peso, Turkish lira and Norwegian krone had each generated returns of more than 10% this year.

The yen has also weakened against almost every major peer over the past week, despite the intervention.

State Street’s Bart Wakabayashi, Tokyo branch manager, says the bank’s proprietary data show that real-money investors remain positioned for carry trades, selling the yen against a range of Group-of-10 (G10) currencies.

The Australian dollar is attracting the most interest, followed by the euro, US dollar, Canadian dollar and pound, he says.

“Unless we see a meaningful turn lower in the dollar and US yields, carry traders may push the pair to retest 162,” Yuxuan Tang, Asia head of rates and forex strategy at JPMorgan Private Bank, tells Bloomberg.

Markets also recognise that repeated intervention is increasingly costly for Japan, she adds.

For investors, that creates a tricky balance. A weaker yen boosts the returns on carry positions, but the prospect of another intervention can suddenly reverse those gains.

The risk is particularly important because carry trades can become crowded.

When a funding currency starts rising sharply, investors may rush to close positions simultaneously, forcing them to buy back the currency they had borrowed and sold.

That can amplify the currency move and trigger losses well beyond the original interest-rate differential.

Attraction of Swiss franc

Reuters reports that the same dynamic is now beginning to affect another traditional funding currency: the Swiss franc.

The franc has long been viewed as a low-yielding currency, although its role in carry trades has been overshadowed by the yen. Switzerland’s persistent current account surplus, sound public finances, low inflation and safe-haven appeal have kept the franc relatively strong.

Reuters notes that it remains 12% stronger against the euro than it was five years ago. That strength has created headaches for Swiss exporters and policymakers, making a weaker franc potentially welcome.

Both the yen and franc can be used to fund carry trades because of their relatively low interest rates.

But the yen’s growing intervention risk is prompting some investors to consider shifting towards the Swiss currency.

“Market participants will be thinking about rotating some of their funding positions,” says Fredrik Repton, senior portfolio manager with the global fixed income and currency management teams at Neuberger Berman.

“If you look at the performance of euro-Swiss, that’s probably more instructive to how the market environment has been shaping up,” he is quoted as saying to Reuters.

Reflecting expectations that the franc will weaken further, Rabobank recently revised its nine- to 12-month target for the euro against the Swiss franc to 0.95 from 0.94.

The attraction of the franc is not simply its interest rate.

Reuters highlights that Swiss rates are currently at 0%, compared with Japan’s 1%, while the franc is also less volatile.

“Not only are Swiss rates lower than the Japanese yen, but (franc) volatility is lower as well,” says Bank of America (BofA) head of global G10 forex strategy Adarsh Sinha.

BofA has a long-standing recommendation to “sell” the Swiss franc against the yen, targeting 190 yen per franc, from 196 currently and 200 before the recent intervention.

Sinha says the recommendation was partly based on Japan’s stabilising balance of payments, but also on the growing attractiveness of funding carry trades in Swiss francs.

Any weakening of the franc resulting from greater use as a funding currency would also be welcomed by the Swiss National Bank, which has said it would intervene if necessary to weaken the currency.

Best run in years

Still, the shift away from the yen is unlikely to happen overnight.

“It’s going to take a lot to shift away from the yen as a funding currency, but there is a lot out there to shake people out of that habit,” says ING global head of markets Chris Turner, according to Reuters.

Turner notes that a shift to using the franc as a funding currency instead of the yen still appears to be in the early stages, but could well take place, telling Reuters: “The Japanese want a stronger yen, the Swiss want a weaker franc, so it would make sense.”

As it stands, the yen remains one of the world’s most actively traded major currencies and therefore retains significant advantages as a funding currency.

But Japanese rate-hike expectations, intervention risk and speculation that Japan’s giant Government Pension Investment Fund could shift more money towards domestic investments are changing the equation.

“The yen remains the world’s dominant funding currency, and the recent intervention has done little to change that underlying reality,” Markus Schmidt, head of linear forex and local-market rates trading in Europe at Credit Agricole CIB in London, tells Bloomberg recently.

As long as Japan’s rate differential with other economies remains wide, carry traders will keep returning to yen shorts, he notes.

According to Reuters, carry trades are enjoying their best run in years, helped by low forex volatility.

The catch is that the strategy becomes much harder to execute once volatility rises because currency swings can quickly wipe out the relatively modest gains from interest-rate differentials.

That is why the next move by the Bank of Japan (BoJ) matters almost as much as intervention.

Bloomberg reports that overnight index swaps imply markets are pricing in one quarter-point BoJ rate hike by October.

Even so, such a move would do little to close the gap with the United States, while subdued US inflation has reduced expectations of an imminent Federal Reserve hike without removing the possibility of further tightening this year.

For now, that keeps the carry trade alive.

Strong demand for carry positions

George Efstathopoulos, a portfolio manager at Fidelity International, sees continued demand for carry positions, albeit with greater volatility given US backing for Japan’s efforts to stabilise the yen.

“For as long as the BoJ is behind the curve, then yen-funded carry trades can continue to flourish,” he tells Bloomberg.

Other investors are taking a similar view.

Damien Loh, chief investment officer of Ericsenz Capital in Singapore, started buying dollar-yen again at around 157 after the latest intervention.

He sees the position not only as a way to earn positive carry, but also as a hedge against other short-dollar positions in his portfolio.

“I like long gold or long Aussie because the dollar debasement narrative is coming back all over again,” Loh says.

“If I didn’t want to have so much dollar beta, I could just buy dollar-yen. So, you have a hedge and it carries positively for you – happy days.”

That enthusiasm comes with an obvious caveat.

Carol Lye, portfolio manager and senior research analyst at Brandywine Global Investment Management in Singapore, says the yen should not rise beyond certain levels if intervention succeeds in preventing further depreciation.

“If intervention is successful in terms of preventing further depreciation, the yen should not exceed 162 levels,” she says, adding that investors could instead fund carry trades in other relatively low-yielding currencies such as the euro or Swiss franc.

For Japanese investors, the post-intervention rebound has also created an opportunity to buy overseas assets.

Bloomberg reports that Japanese investors bought the most foreign assets in more than two years last week, taking advantage of the yen’s brief rally.

That could add another layer to the currency dynamics.

If traders come to expect further intervention or follow-up action from the BoJ, the yen could become a less attractive funding currency – not because its interest-rate disadvantage has disappeared, but because the risk of violent reversals has increased.

For now, however, the numbers still favour the carry trade.

As long as Japan’s rates remain well below those of the United States and other higher-yielding markets, investors have a powerful incentive to keep looking for ways to borrow yen cheaply and put that money to work elsewhere.

And if the yen gets another boost from intervention, some traders may simply see it as another chance to sell.