Opposing views about carry trade

One view is that the huge shakeout of yen-funded trades has left the FX market in a more balanced position, and ready to re-engage carry trades, particularly given how asset prices have been rebounding. The opposite, more sinister view, is that the unwinding of carry trades in early August was just the tip of the iceberg, and more financial market turbulence is in store as carry trade unwinds continue and even escalate in the future.

On the first of these views, it is notable that some data that relates to carry-trade activity suggests that yen-funded positions may have been cleared out completely, spurred on by that huge near-ten yen slide in US dollar/yen in the days following the surprise BoJ rate hike on July 31^st.

Data from the Commodity Futures Trading Commission CFTC, for instance, show that net short-yen contracts stood at more than 180k just ahead of the BoJ meeting but, as of the latest report, for the week ending August 20^th, this short position has been switched to a net long-yen position of nearly 24k contracts. That’s a huge turnaround in such a short space of time and seemingly indicative of a massive clear-out of yen-funded carry trades by non-commercial (speculative) traders.

In the days and weeks, following the early August meltdown, we have seen not just Japanese asset prices, such as equities, rally hard, but other assets have risen as well, no doubt helped by increased speculation of Fed easing next month. Does this removal of short-yen positions shown in the CFTC data, and subsequent rally in asset prices mean that we can all breathe a sigh of relief over the carry trade? The risk of another dramatic plunge in US dollar/yen and plunge in risk assets is low given the position clear-out that’s suggested by the CFTC data? Recent research from the BIS suggests that we might need to be cautious here.

The authors claim that the carry-trade evidence that we gain from speculative trading within the CFTC data is just a fraction of carry-trade activity if we consider other forms of yen lending as a version of the carry trade. For instance, international yen loans to non-banks could be considered as versions of the carry trade when you think that global borrowers are unsurprisingly attracted to funding in the currency with the lowest interest rates.

Since the pandemic (Q4 2020), we have seen international yen loans rise a huge 42% while, more expensive, international loans in US dollars are basically the same today (the latest data are for Q1 2024) as they were at the end of 2020. Should these yen borrowers cash out, the yen could surge again.

However, Steve Barrow, Head of Standard Bank G10 Strategy, said there are three points that counter the BIS’s alarm. One is that while international yen loans have risen sharply, they are small in global terms. For instance, they are less than one twentieth of international dollar loans to non-banks. Hence we’d question the extent to which liquidation of these yen loans can create a global stir.

A second point is that such lending may not be a true carry trade in the sense that yen borrowers won’t panic to pay down the loans just because the yen has rallied. For instance, such borrowing might be used to fund long-term investment projects, not short-term long positions in high-yielding currencies, as we might expect to find in the CFTC data.

A third point, which relates to the first, is that, even if the yen-funded carry trade is coming to an end, the backdrop of falling policy rates elsewhere, particularly in the US, should cushion the blow. “When we put these points together it strikes us that fears about further carry-trade explosions are probably misplaced. That does not necessarily mean that we expect the yen to weaken. In fact, we see more strength. However, we see this as occurring in a more sedate and orderly way; not the panic-driven, carry-unwinding way that we saw earlier this month,” said Steve Barrow.