By Alun John and Tom Westbrook
LONDON/SINGAPORE (Reuters) -The Bank of Japan’s move to raise interest rates to a 15-year high has lifted the yen to its strongest level against the dollar since March, setting it up for further gains , as investors begin to reassess their carry trades once the favorite play of the year.
The shift will come as a relief to Japan’s finance ministry, which spent 5.53 trillion yen ($37 billion) in the currency market this month to support their currency, data showed on Wednesday, their second set of interventions of the year.
Wednesday’s rate hike was the biggest since 2007 and came just months after the BOJ ended eight years of negative interest rates. Governor Kazuo Ueda also did not rule out another rate hike this year and emphasized the bank’s willingness to continue raising financing costs to levels considered neutral for the economy.
The dollar fell 1.7% against the Japanese currency to 150.2 yen after the BOJ’s move and is now more than 10 yen lower than early July’s level of 161.9.
That July level was the weakest level for the Japanese currency since 1986. The yen came under heavy pressure as favorable market conditions and a wide gap between financing costs in Japan and those elsewhere made the yen a popular choice as financing currency for carry trades.
These see investors borrowing in a currency where interest rates are low (the yen is popular) and then exchanging it for another currency where they can invest in higher-yielding assets.
They were very popular with investors earlier this year as global interest rate cuts expected in early 2024 were postponed and currency prices were stable. Sudden price fluctuations can wipe out gains from yield differentials.
But with the BOJ raising rates at a time when central bank cuts around the world are finally gaining momentum, investors are changing course.
“It is the rate of change (of interest rate differentials) that matters. And so if the BOJ increases the pace of rate hikes relative to market prices, and if the Fed also comes into play here, then the pressure on carry trading will increase,” said James Malcolm, head of FX strategy at UBS.
The Federal Reserve held rates steady on Wednesday but opened the door to cutting borrowing costs once its next meeting in September, as inflation remains in line with the U.S. central bank’s 2% target.
“Hedge funds are likely to reassess their strategies in light of these developments,” said Tareck Horchani, head of prime brokerage at Maybank Securities in Singapore.
“This shift could reduce the attractiveness of short yen positions, as the narrowing interest rate spread between the BoJ and other central banks, especially the Fed, which is expected to cut in September and December, makes the yen less attractive for carry trades. “
PACE AND VOLATILITY
While it is difficult to estimate the exact number of global positions in yen-funded carry trades, and therefore the impact their unwinding could have on the currency, many speculative positions are based on pure currency swaps between the yen and higher yielding currencies.
There are also hundreds of billions of dollars of yen-funded short-term investments.
For example, yen-funded carry trades in US government bonds are yielding almost 6% – a powerful incentive for market participants that Japan has so far found difficult to counter. The BOJ’s 15 basis point interest rate hike will only marginally erode the carry on such transactions.
But what could disrupt trading and force liquidation is volatility.
“The carry trade works when volatility is low, but when that volatility increases, people will unwind their positions,” said Yusuke Miyairi FX strategist at Nomura.
That is rising and implied volatility between the dollar and the yen rose to 27% on Wednesday, the highest level this year.
It’s not just the BOJ’s move on Wednesday that has shaken the yen, as the MOF’s intervention earlier in July halted the currency’s decline. Comments from Republican presidential candidate Donald Trump criticizing Japan for yen weakness and changing Fed expectations played a role.
These factors have already caused carry trades to be phased out, with knock-on effects on currencies from Mexico to Switzerland.
CFTC data shows speculators’ bearish bets against the yen are down 40% from a nearly seven-year high in April, but at a still high $8.61 billion.
And there is still room for a more dramatic move in the yen.
“You can’t discount the idea that we could have a five- or seven-day move in one day, or even reach the historic extremes of 10 (yen),” UBS’s Malcolm said.
“In 1998 we had two consecutive days of 10 (yen) moves in the dollar/yen. This is what the end of the carry trade looks like. That is what we have seen in the past and this is what the setup still looks like today out.”
