The Japanese yen experienced turbulent fluctuations following a significant policy change by the Bank of Japan (BOJ) on Friday. This move has the potential to disrupt the popular carry trade strategy, as the yen is expected to strengthen, leading to increased currency costs for traders.
While the BOJ maintained its short-term interest rate target below zero, it surprised markets by adjusting its policy that had previously kept the 10-year government bond yield capped at 0.5%.
The immediate response from traders and investors was one of confusion, as the implications of the policy shift were not immediately clear. However, two key takeaways emerged from the market reaction: the yen’s trading will become choppy, and its fluctuations will have ripple effects beyond Japan’s borders.
A surging yen carries significant consequences for risk assets, which have benefited from the ample global liquidity that the BOJ has exported over the years. Through a carry trade mechanism, investors have been leveraging cheap yen to make bets in higher-yielding currencies such as the US dollar or the Mexican peso, thereby profiting from the interest rate differentials.
The interconnectedness of various markets and the flow of global liquidity play a crucial role in this process. Simon Edelsten, a global equities fund manager at Artemis, explains that the creation of liquidity from low-cost Japanese money ultimately finds its way into risk assets, influencing prices across different financial instruments.
The yen’s performance on Friday showcased its volatility, strengthening by up to 1.2% against the dollar before weakening by 1% and eventually settling around ¥139 per dollar. The yen has faced downward pressure in recent times due to the divergence in interest rate policies between the BOJ and other central banks, but the trend now seems to favor yen strength.
Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management, suggests that the BOJ’s policy shift highlights a bias towards a stronger yen. Mitra anticipates the yen’s value to potentially reach the low to mid 130s area as yields compress.
The widening gap between Japan’s lower yields and those of other countries in 2022 prompted both domestic and foreign investors to seek higher-yielding alternatives abroad, leading to a sell-off of Japanese assets. The yen has been a popular choice for carry trades, losing 25% against the Mexican peso and 10% against the pound in the last 12 months. However, this trend may change if the yen appreciates further.
Mitra predicts that carry trades might come under pressure if the yen appreciates by 2-4%, as it would erode expected returns. Nonetheless, the yen’s attractiveness as a funding currency remains, given that Japanese yields remain significantly lower than those in other economies.
Kit Juckes, head of FX strategy at Societe Generale, concurs that carry trades will become less profitable in the face of potential yen appreciation. However, he foresees any yen appreciation to be gradual, making carry trades still worthwhile in the present context.
One of the difficulties in predicting the consequences of the BOJ’s policy shift is the level of understanding among investors regarding the new approach. The complexity of the new policy and the various variables involved make it challenging for the market to grasp fully. James Malcolm, head of FX strategy at UBS investment bank, points out the intricacies of the BOJ’s approach, which requires considerable effort and time to comprehend fully.