The recent unwinding of the yen “carry trade” could remain a long-term headwind amid already turbulent markets. The popular trading strategy among hedge funds — in which an investor borrows in a certain currency with low interest rates to buy higher-yielding assets elsewhere — began to fall apart last week when the Bank of Japan unexpectedly raised its benchmark interest rate and followed up with currency intervention. These moves caused the once stable —and cheap — yen to appreciate sharply against the dollar. The yen gave up some of those gains on Thursday as markets rebounded, however, and it was last at roughly 147 per U.S. dollar. It had strengthened at one point earlier in the week to 142 yen per U.S. dollar. JPY= YTD mountain The Japanese yen’s appreciation against the U.S. dollar marked the unwinding of the so-called carry trade. But judging by past corrections, the true conclusion of the unraveling of the carry trade could take years, according to Shaun Osborne, Scotiabank managing director and chief FX strategist. He pointed to corrections in 2008 tied to the financial crisis, in 2014-15 when the U.S. Federal Reserve began tapering and raising rates, and the volatility in 2019 that preceded the Covid pandemic as examples of how long this process could be drawn out. Following the financial crisis in 2008, for example, the dollar took until mid-2015 to recover to pre-crisis levels seen in 2007 versus the yen. “There’s still quite a significant yen short position out there,” Osborne said. He estimates that there’s still a roughly $15 billion yen short position through July 30, still to be covered. In other words, that short position could drive more strength in the yen as that position is covered. The trade, which involves investors borrowing yen and converting the currency to dollars for a higher yield, has been one of the drivers of the recent market sell-off and persisting volatility. Markets remain jittery as investors continue to weigh recession risks in the U.S. tied to weaker-than-expected jobs data. “We don’t always get these corrections in one fell swoop. Everyone’s been sitting around the table feasting on juicy carry returns, and now everyone is trying to get out at the same time. … It can get messy really quickly,” he added. As of Wednesday, Osborne estimates short traders have only given up 5% of their gains on the trade over the past year. Osborne cited two key measures, the Bloomberg G10 Carry Index and the Bloomberg GSAM FX Carry Index, which show an average shakeout of around 10% in periods of correction. “Positioning in yen futures shows traders have pushed their short position to levels last seen in 2007, [and] it took years for that position to [unwind],” said Rob Ginsberg, managing director at Wolfe Research. Could BOJ make things worse? The Japanese central bank said on Tuesday that it would not raise rates further while markets remain exceedingly delicate. But catering to sell-off events in markets could also end up being a policy mistake, Ginsberg added. “I always worry when central bankers capitulate to recent market action,” Ginsberg said. “It’s almost like markets are gonna punish them more.” Ginsberg noted that further appreciation for the yen against the dollar could be on the table, and didn’t rule out a roughly ¥130 to USD support level in the next 12 months. JPY= ALL mountain Dollar/Yen, long term Risks also linger if the BOJ doubles down on its commentary from Tuesday and decides to push out further rate cuts, which could cause activity tied to the carry trade to increase in the short-term. “If the BOJ delays interest rate hikes further out, new Yen carry trades will be put on while the BOJ must ponder for the next series of hike(s), creating the risk of an even greater unwind than seen so far,” Fed Watch Advisors chief investment officer and founder Ben Emons wrote on Wednesday. Osborne, however, doesn’t expect the BOJ’s comments to fully reignite the carry trade. He said it is “wishful thinking” on the part of equities traders. To bring the carry trade back full force, traders will need a confluence of factors: lower market volatility and greater visibility as to where interest rates in Japan are headed for the next 12 months, he said. In the meantime, traders could rely more heavily on other currencies to execute the trade, including the Swiss franc, the Mexican peso and the Chinese renminbi, Osborne said.
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