Will another carry-trade episode emerge?

This week sees another round of central bank meetings. After the ECB kicked things off last week, the likes of the Fed (Wednesday), BoE (Thursday) and Bank of Japan (Friday) will dominate market attention. The last time the Bank of Japan (BoJ) met, we saw a huge unwinding of carry trades as the Bank hiked rates. The BoJ almost certainly won’t hike rates again this week, but this need not necessarily rule out another painful carry-trade unwind.

There are clearly a number of moving parts to any carry trade: the funding rate, FX volatility, and the rate of return available on the target currency. The massive carry trade unwind in early August was based on the first two of these. The surprise BoJ rate hike on July 31^st lifted the funding rate for the carry trade while, in the background, the BoJ’s numerous bouts of intervention to try to lift the yen made FX volatility soar. It did not really matter what the third component, the prospective return on target currencies, was doing as higher Japanese rates and a surge in the yen were sufficient to make carry-traders run for the hills.

The Bank for International Settlements (BIS) produced more evidence in a report issued recently showing the extent to which the carry trade had become very crowded ahead of the early August meltdown, hence the fallout, when it came, was quite spectacular. It is difficult to say how much of the yen-based carry trade has been unwound.

Data from the CFTC shows that, amongst non-commercial traders, the entire stock of short-yen positions has been reversed. In fact, the turnaround has been so dramatic here that the latest CFTC data on the yen shows that long yen positions are now at their highest since 2016, after yen shorts had been nearly the largest ever in early July.

It is a spectacular turnaround and must have some thinking that the yen-funded carry trade is now totally liquidated and that there is no further threat. Add to this the fact that expectations for the next BoJ rate rise are not until much later in the year, even 2025, and it seems as if the danger to the carry trade from higher Japanese rates is also low at the moment.

Nonetheless, there are still reasons why it might be premature to declare that carry trade risks have disappeared. For a start, the Fed seems to be on course to cut rates this Thursday, and this could have two effects on the yen-funded carry trade, perhaps especially if the Fed cuts a full 50-bps. The first comes from the fact that, while rising Japanese policy rates might hit the yen-funded carry trade, so could rapid rate cuts in the US, because the more US policy rates come down, the more the dollar might start to replace the yen as the funding currency of choice.

Now clearly, with a 5%-plus gap between policy rates in the US and Japan right now, there is still a considerable way to go, it would seem, before any transition from yen funding to US dollar funding might occur. However, if we also add in the currency volatility issue, we see that the US dollar is actually quite stable against many other currencies, whereas yen volatility is still sky high, and that suggests the risks of a further surge in the value of yen still exist while the threat of a surge in the US dollar appears much more modest.

Hence, when we put together the expected fall in US policy rates with the more modest US dollar volatility, it does seem as if the case for switching carry-trade funding from yen to US dollars is rising and will increase further as the Fed continues to trim rates. A second effect on the yen funded carry trade from Fed easing is that cuts in the US could encourage other central banks, especially in emerging markets, that it is safe to cut their own rates.

As many of these currencies act as the target for yen-funded carry trades, so the fall in policy rates lowers the attraction of the carry trade. This too could mean that Fed rate cuts, particularly aggressive ones, could just provoke more unwinding of the yen-funded carry trade if, indeed, all of the carry traders have not been carried out already.