Yen Carry Trade Signals Uncertain Times Ahead

Amid all the market volatility last week, there was one notable standout from the crowd as investors increasing sought the safety of haven assets: USDJPY. The pair failed to rise despite speculators pouring into the dollar after fleeing risk assets to choose quality over yield. While confusing to some as expectations were for the USDJPY currency pair to appreciate, its status as one of the popular carry-trades amongst institutional investors saw a brief unwind last week as sophisticated traders moved to lower exposure by reducing both risk and leverage.  Movements by the self-styled “smart money” should not be taken for granted as they often denote a shift in prevailing market conditions and are worthy indications of approaching troubles on the horizon.

The Fundamental Perspective

The Yen carry-trade has been a popular funding mechanism for sophisticated investors for over 15-years after the Bank of Japan made the stunning introduction of zero interest rate policies back in 1999.  In order to tackle deflation that was harming growth, the Japanese were among the first developed nations to really experiment with the possibilities of monetary policies.  However, when it comes to extreme policy measures, they are generally incentivizing investing activities that are not necessarily beneficial or useful.  The idea in principle of a carry-trade is to borrow in a lower-yielding asset to buy a higher-yielding asset.  The difference between the yields is called the carry.  In the case of the Yen carry-trade, traders used Yen as the funding vehicle to invest in other, higher risk currencies that provided better yields. 

In carry-trades in currencies, the carry is determined by the prevailing interest rates of the two currencies traded in the pair, meaning that borrowing at 0.00-0.10% to invest at 0.75-1.00% could provide attractive leveraged returns and prove a great mechanism for borrowing in the market.  This trade became so popular amongst institutional investors and speculators that it substantially dropped the value of the Yen against peers like the US dollar.  However, in 2008, as margin calls climbed, the USDJPY carry-trade was quickly unwound and in the years subsequent to the crisis saw the Yen appreciate further until the introduction of “Abenomics” reversed the slide in the pair.  The idea of printing more money to keep the currency in a more competitive state was popular amongst policymakers as a way to reinstate export growth in an economy struggling to exit the deflationary cycle.

Fast forward to the present day and last week’s unwind should raise some concerns.  Although the Japanese Yen is no longer viewed within the context of a haven asset owing to the extremely high debt-to-GDP ratio of Japan, it times of uncertainty it is still likely to appreciate on the back of traders exiting Yen carry-trades.  The immense volatility last week saw this move rapidly occur with the USDJPY offered heavily in in reaction to the uncertain conditions emanating from Europe and China. While this has seen a modest rebound in the pair on the back of a “risk on” mentality prevailing in global financial markets, any future unwind should be taken as a strong signal about the relative health of the market and the strong possibility of another round of turmoil imminently hitting financial market on the back of the growing risks.

The Technical Take

Since the introduction of “Abenomics”, the Japanese Yen has been hurtling lower against peers, aided in part by the expanded quantitative and qualitative easing measures undertaken by Bank of Japan Governor Haruhiko Kurdoa.  The rapid rise in the USDJPY pair over the last several years comes of the heels of these policy moves with the pair touching highs in early June last witnessed in 2002.  Momentum higher has been subdued as the pair undergoes a slight technical correction following the latest move higher.  Nevertheless, the pair continues to trend higher as evidenced by the equidistant channel technical pattern setting up in USDJPY since November of last year and confirmation from moving averages which indicate further upside. 

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Conclusion

Renewed Yen selling over the past session comes amid greater market optimism that the latest aggressive moves by sovereigns and central banks will continue to support the prevailing direction of financial markets.  Nevertheless, should risk rear its ugly head and force investors to once more clamor for safety, the first place to watch for downside in the Yen carry-trades.  Besides providing a strong indication of the positioning of institutional investors, the Yen is highly reactive to changing conditions and often serves as the first bellwether signaling the time to pare risk and make the switch from higher yielding assets back to quality assets.