By Alun John and Tom Westbrook
LONDON/SINGAPORE (Reuters) – The Bank of Japan’s move to raise interest rates to a 15-year high pushed the yen to its highest level against the dollar since March and left it poised for further gains as investors reassess lucrative carry trades that had previously been a favorite this year.
The shift will come as a relief to Japan’s finance ministry, which has spent 5.53 trillion yen ($37 billion) in the foreign exchange market to support its currency this month, data showed on Wednesday, the second round of interventions this year.
Wednesday’s rate hike was the biggest since 2007 and came just months after the Bank of Japan ended eight years of negative interest rates. Moreover, Governor Kazuo Ueda did not rule out another hike this year and stressed the bank’s readiness to continue raising borrowing costs to levels deemed 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 about 10 yen lower than its early July level of 161.9 yen.
The July level was the weakest for the Japanese currency since 1986. The yen has been under heavy pressure amid favorable market conditions and a wide gap between borrowing costs in Japan and those elsewhere that has meant it has been a popular choice as a funding currency for carry trades.
This method allows investors to borrow in a currency with low interest rates – the yen was very popular – and then exchange it for another currency that they can invest in higher-yielding assets.
These bonds were popular with investors earlier in the year as global interest rate cuts that had been expected in early 2024 were postponed, and currencies stabilized — sudden price swings can wipe out gains from yield differentials.
But with the Bank of Japan raising interest rates as central bank cuts around the world finally gain momentum, investors are changing course.
“It’s the rate of change (in interest rate differentials) that matters,” said James Malcolm, head of foreign exchange strategy at UBS. “If the Bank of Japan accelerates the pace of rate hikes relative to market rates, and if the Fed also becomes involved, the pressure on the carry trade will increase.”
The U.S. Federal Reserve kept interest rates steady on Wednesday but opened the door to lowering borrowing costs as soon as its next meeting in September as inflation continues to match the U.S. central bank’s 2% target.
“Hedge funds are likely to reassess their strategies in light of these developments,” said Tariq Horshani, head of prime brokerage markets trading at Maybank Securities in Singapore.
“This shift could reduce the appeal of short-term yen positions, as the narrowing interest rate differential between the Bank of Japan and other central banks, especially the Federal Reserve, which is expected to cut rates in September and December, makes the yen less attractive for profitable carry trades.”
speed and volatility
While it is difficult to measure the exact size of global positions in yen-funded carry trades, and thus the impact their liquidation might 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 in short-term investments funded in yen.
For example, yen-funded margin trades in US Treasuries yield about 6% – a powerful incentive for market participants that Japan has struggled to counter so far. A 15 basis point interest rate hike by the Bank of Japan would erode the “spreads” on such trades only slightly.
But what can flip trades and force liquidation is volatility.
“Carry trades work when volatility is low, but if volatility rises, people will liquidate their positions,” said Yusuke Miyari, foreign exchange strategist at Nomura.
This is increasing, with implied volatility in the USD/JPY pair jumping overnight to 27% on Wednesday, its highest level this year.
The Bank of Japan’s move on Wednesday wasn’t the only reason the yen was shaken. The Finance Ministry’s intervention earlier in July had halted the currency’s slide. Republican presidential candidate Donald Trump’s comments criticizing Japan for the yen’s weakness and the Federal Reserve’s shifting outlook were among the factors.
These factors have already led to a decline in carry trades, which has had a negative impact on currencies from Mexico to Switzerland.
Data from the Commodity Futures Trading Commission shows that speculators’ bearish bets against the yen are 40% below their nearly seven-year high hit in April, though they are still high at $8.61 billion.
There is still room for the yen to move more dramatically.
“You can’t rule out the idea that we could see a one-day move of five or seven yen or even historic highs of 10 yen in a single day,” said Malcolm of UBS.
“In 1998, we had two consecutive days of 10 (yen) moves in the dollar/yen. That’s what carry trade liquidation looks like. That’s what we’ve seen in the past and that’s what it still looks like today.”
