The Japanese yen, long a favored currency for carry trade strategies, is now facing a period of significant reversal. Historically, Japan's negative interest rates and a weakening yen made it an attractive proposition for investors seeking higher returns. By borrowing yen at low rates and investing in higher-yielding assets, traders could profit from both interest rate differentials and potential currency deprecation. However, this dynamic has shifted dramatically in recent months. According to UBS, the notional value of USDJPY carry trades rose to $500 billion from 2011, with roughly half of that activity concentrated in the past two to three years. A substantial portion of these trades, estimated at $200-250 billion, has been unwound in recent weeks alone. JP Morgan estimates that as much as three-quarters of carry trade positions have been closed, wiping out gains accumulated from the first half of this year.
While the unwinding of the USDJPY carry trade is likely to continue, the most acute market pain may be behind us. Future movements in interest rates and broader financial market conditions will play a crucial role in determining the yen's trajectory. Given the historical average of 110-112 for the USDJPY pair between 2015 and 2020, the yen still has room to strengthen.
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When following the JPY price action, it is worth bearing in mind what happened to the yen in the early 1990s and then after 2007. This is when investors started to reduce carry trades. In terms of undervaluation, it can be seen that the USDJPY pair was about 2 times deviated from the 1-year average in the early 1990s and 2007. Subsequently, an over-strengthening signal was generated when it deviated 2-3 times in the other direction. Currently, from a 2-fold positive bias, the USDJPY has fallen to a 1-fold negative bias (hence a possible positive reaction). Nevertheless, if history were to repeat itself, there is still plenty of room to fall, given that the USDJPY was then falling to at least 2-3 times negative bias. What's more, the USDJPY downtrends then lasted for decades at a time. Source: Bloomberg Finance LP, XTB
The persistence of carry trade unwinding is supported by the behavior of yen futures contracts. The extreme short positioning in yen futures, which had ballooned to around 240,000 contracts, has contracted to 140,000. In contrast, long positions have surged to 65,000 from a mere few thousand in 2020.
Speculators assume that the Bank of Japan (BoJ) could raise interest rates as high as 1% in the coming months, while according to market the Federal Reserve is expected to cut rates by 100 basis points this year. Although these expectations may be somewhat exaggerated, they underscore the potential for continued capital flows from the dollar to the yen.
Short positions on the yen are being extremely reduced. Will this trend continue and will the yen soon be more bought than sold by speculators? Source: Bloomberg Finance LP, XTB
The availability of cheap yen-denominated loans has contributed to significant price growth pressure across multiple markets, including a potential impact on the US technology sector. This sector has faced mounting challenges recently, characterized by declining stock prices and a failure to meet investor expectations on financial performance.
Although the largest number of carry trades took place on the USDJPY pair, it is also worth remembering that investors also used the franc and Chinese yuan in such transactions, so the current trend of reversal of the situation on the yen may also affect these currencies.
Quite a few assets such as Bitcoin, Nasdaq futures or currencies like COP, MXN, PLN or BRL are vulnerable to weakening if the yen strengthens further. On the other hand, we have the TRY, for example, which has been oversold despite high interest rates. Recently, however, there has been growing interest in the Turkish lira given the still high interest rate levels. Source: Bloomberg Finance LP
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