Switch carry funding

The FX carry trade has performed well in the first two months of this year

With Japanese policy rates likely to rise soon the yen’s days as the best funding currency may be nearing an end. But which currency is likely to take over?

So far this year the carry trade has delivered a return of around 3.5% within the G10 currency space (this is using the Bloomberg measure where the three highest-yielding G10 currencies are held against the three lowest yielding currencies). That’s a stellar gain when you consider that the return for the whole of 2023 was around 3%. But clearly there is no guarantee that such a strong performance will continue.

Indeed, with Japanese policy rates likely to rise, the seemingly dominant funding currency – the yen – could rally and so cut down carry-trade gains, in addition to the pressure on returns that will come when other higher-yielding G10 countries start to cut rates. Faced with this risk, how should carry-traders proceed?

One option is clearly to stand firm and persist in funding higher-yielding currency positions with the yen. After all, the BoJ is not likely to lift rates by much this year (we see 35-bps in all). However, carry trades can suffer if the funding currency rallies and even though rate hikes in Japan will probably be small, the Bank will be going in the opposite direction to all other G10 central banks and this could make the yen recover a good part of the huge losses made in recent years.

Other candidates for funding carry trades include the Swiss franc and dollar, and perhaps the euro as well. Of these we’d focus on the Swiss franc for a number of reasons.

The first is that the SNB has effectively achieved its inflation target. Annual inflation fell to 1.3% in January; the lowest since 2021 and clearly within the SNB’s inflation target (which, it should be noted, is an inflation rate below 2%, not the 2% figure that most others target).

A second point is that such good inflation progress could not only produce rate cuts this year, but seemingly a more aggressive policy than others. This is because the SNB only has four meetings per year against the eight that we see for most central banks. This could mean that it starts earlier than most (the next meeting is later this month) or cuts by larger amounts (50-bps as opposed to 25-bps).

Another factor here is that the SNB does not give the same sort of pre-warning about imminent policy changes as the likes of the ECB and Fed and this can mean a larger (negative) reaction in the franc when rates are cut. And thirdly, the SNB has actively used currency manipulation to achieve its inflation aims. When inflation started to soar, the Bank was keen to allow the franc to rise, but now that inflation seems becalmed the pressure is off. This too suggests to us that there has been a rise in the attraction of the franc as a funding currency for the carry trade; something that we expect to continue.

What does all this mean for the carry trade in 2024? Generally speaking, we think that the prospects are good. However, while recent years might have been dominated by low yen rates, yen weakness and increasingly high rates elsewhere as monetary policy was tightened, 2024 may see a switch in yen funding to the Swiss franc as the franc falls and the yen rises.

We look for the franc to fall by up to 15% against the yen this year. Another consideration is that there may be a modest narrowing of rate spreads between other G10 countries and Switzerland as policy is eased across the G10 space (with the exception of Japan) and hence the interest pick-up from the carry trade probably won’t be as high as it has been in recent years. Nonetheless, we see a squeezed return here as being compensated by franc weakness, meaning that franc-funded carry trades should still deliver the goods in 2024.