What if the yen-funded carry trade stays out of fashion?

The yen-financed carry trade suffered a double-whammy recently with the BoJ intervening to buy the yen, and delivering a surprise rate hike. The US dollar/yen fell from a high of near 162 in early July to a low of 141.70 just a few weeks later. A 12.5% rally in the yen, or any developed currency for that matter, in such a short space of time is not just highly unusual, it is a destroyer of carry trades. After this episode, a number of questions arise. The first is whether there’s anything similar that’s happened before that might offer a guide to where the yen carry trade goes from here. And the second relates to whether there are any alternatives to the yen when it comes to funding currencies for the carry trade.

On the first of these, the truly dramatic surge in the Swiss franc back in January 2015 may offer some guidance to the future of the yen carry trade. If you remember, back in 2015 the Swiss National Bank suddenly abandoned its defence of the 1.20 level against the euro. This was a huge decision as euro/Swiss had basically sat on the 1.20 level for much of the prior three years.

During this time, those using the franc to fund carry trades seemingly had the security of knowing that the franc could not appreciate – because the SNB was holding the euro /Swiss above 1.20. That’s like manna from heaven for carry traders – up until the point that this support from the SNB melts away, as it did in January 2015. The result was a surge in the franc of close to 30% against the euro on the day that the 1.20 floor was removed. It makes the yen’s recent surge look like child’s play. But what happened after that fateful day in January 2015? Did the franc continue to rise as more carry trades were unwound? Or did the scale of that franc surge clear out all of the carry-trade positions, leaving the franc to weaken again? The answer may be the latter. After slumping to a low of around 0.85 on the day of the SNB’s actions, the euro/swiss basically spent the next three-and-a-bit years getting back to 1.20.

In short, it seemed that there was such a dramatic shake-out on January 15^th 2015 that traders, including carry traders, felt emboldened enough to see renewed value in franc-based carry trades once the shake-out was over. If this acts as a template for the yen now, it would seem that the yen is likely to start weakening again; possibly all the way back to the 160-plus region against the US dollar.

However, the shake-out of yen-funded carry trades this month would appear to be far less significant than that seen for the franc in 2015 if only because the yen has rallied by far less. In other words, carry traders might have been sure back in 2015 that there was limit ed upside for the franc once the SNB had removed the 1.20 floor and the market had reacted. This made them willing to short the franc again to buy higher-yielding currencies. But today, can the market be so sure that the rally in the yen is over? Steve Barrow, Head of Standard Bank G10 Strategy, doubts it. Hence, as a template, the 2015 carry-trade capitulation in the franc might not serve as such a good role model. Indeed, that’s his view given that we see the dollar/yen falling to the 130 level over the next year, or two.

If this means that the yen-funded carry trade stays out of fashion for a while, what other currencies could take its place? The franc itself might seem to be one, although the currency has been in a steady uptrend against the euro since returning to 1.20 in 2018. That might put off some carry traders who fear that this uptrend for the franc could wipe out any interest gain from buying higher-yielding currencies. Could the dollar become the carry-trade darling? Here too, the trend has been mostly upward, and, of course, US short-term rates are high even if they are about to be reduced by Fed easing.

“In short, it does not seem as if any good carry-trade alternatives exist, and this might draw investors back to the yen again. But, as we’ve explained above, we feel that this could be a trap, meaning that those anticipating that the heady days of the carry trade will return are likely to be disappointed,” said Steve Barrow.