Understanding the Japanese Yen Carry Trade: Implications and Insights

Introduction

Japan’s yen hit mid-January highs around 145.28 in Monday’s intraday deals, extending its recent appreciation against the US dollar. Japan’s currency has appreciated by 10 percent against the dollar in just over three weeks, partly driven by the Bank of Japan’s (BoJ’s) 15-basis points rate hike to 0.25 percent last week. Earlier, on March 19, the Japanese Central Bank first hiked interest rates after 17 years to 0.10 percent. Last week, the BoJ also announced it would halve its monthly bond purchases over the next couple of years to strengthen the currency and economic growth. This move, however, is expected to adversely impact the carry trade. 

Japanese Yen: A Currency Safe Haven

The Japanese Yen has long been considered a safe haven and a favorite among global investors for carry-funding options due to the low cost of borrowing. Analysts at Barclays believe that the Japanese currency was the most overbought among G10 majors, indicating that the “bar for yet more outperformance in the near term appears high.” The fear of unwinding Yen-based carry trades has significantly impacted global market sentiment.

What is a Carry Trade?

Carry trade is a trading strategy that involves borrowing money at a low-interest cost and investing it in other assets that provide higher returns. This strategy is popular among forex traders who borrow from a country with low-interest rates and a weaker currency and reinvest the money in another country for higher returns. For 17 years, the Bank of Japan’s ultra-loose monetary policy and the consistently weak yen made the Japanese currency a preferred choice for global investors engaged in carry trade.

Reasons Behind the Unwinding of Yen Carry Trades

The Japanese Yen has appreciated by 10% over the last three weeks, from levels of 161 on July 11 to 145 now. As the Yen appreciated against the US dollar, investors had to rush and unwind their carry trade to cut losses. As a result, it unsettled the US markets. 

Implications for India: Should We Worry?

According to the National Securities Depository Limited (NSDL), Japanese foreign portfolio investors hold equities worth Rs 2.05 trillion in India. A stronger Yen would prompt some selling by these investors, potentially affecting the Indian market.

Example of a Yen Carry Trade

Let’s consider an example to simplify the understanding of Yen carry trade. Suppose an investor borrows 1 million Yen at an interest rate of 0.25% from Japan and converts it to US dollars when the exchange rate is 1 USD = 100 Yen. The investor now has $10,000. The investor then invests this amount in US bonds that offer a return of 2.5%.

Interest paid in Japan: 0.25% of 1 million Yen = 2,500 Yen

Return on US bonds: 2.5% of $10,000 = $250

If the exchange rate remains constant, the investor gains the difference between the interest rates, which is a positive return. However, if the Yen appreciates significantly, the investor might face losses when converting the dollars back to Yen, prompting the need to unwind the trade.

Conclusion

The recent appreciation of the Japanese Yen and the BoJ’s monetary policy changes have significant implications for the global financial markets, particularly for those involved in carry trades. 

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.