Bank of Japan’s policy shift strengthens and increases volatility of yen
Bank of Japan's policy shift strengthens and increases volatility of yen
The Japanese Yen’s Turbulent Journey: Threatening the Carry Trade and Global Markets
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LONDON/SINGAPORE, July 28 (ANBLE) – The Japanese yen is on a bumpy path towards strengthening after Friday’s central bank policy change, threatening to upend the carry trade, one of this year’s most popular strategies, as the currency inevitably becomes more expensive.
The Bank of Japan (BOJ) has kept its short-term interest rate target below zero but has shaken markets by adjusting a policy that had effectively capped the 10-year government bond yield at 0.5%. This unexpected move has led to wild swings in the yen’s value, making it the most volatile trading day for months. Traders and investors were initially confused about the implications.
The first clear consequence is that trading in the yen will become choppy, affecting markets beyond Japan. A skyrocketing yen has major implications for risk assets, which have been partially supported by the trillions of dollars in global liquidity exported by the BOJ. This impact is seen in the carry trade, where investors borrow cheap yen to fund bets in higher-yielding currencies, such as the dollar or the Mexican peso, making money on the interest rate difference.
Simon Edelsten, a global equities fund manager at Artemis, explained, “All these markets are linked together in terms of global liquidity flows. People borrow in yen to buy dollars, dollars sit around looking for something to do, people say we might buy Treasuries or Apple. All this liquidity creation out of cheap Japanese money feeds into risk assets – at the margin, but enough to move prices.”
The yen has been under heavy pressure in the past 12 months due to other central banks raising rates while the BOJ kept borrowing costs low. However, it is now believed that the yen’s overall direction will be toward strength. Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management, said, “The BOJ’s shift underscores a strengthening bias in the yen. I wouldn’t be surprised to see it go to a low to mid-130s area because we are looking at yields compressing.”
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Riskier Gold Seam
Japan’s low yields relative to those elsewhere created a significant gap in 2022, leading both domestic and foreign investors to dump Japanese assets in favor of higher-yielding alternatives overseas. The yen served as an obvious base for carry trades, with a 25% depreciation against the Mexican peso and a 10% depreciation against the pound in the last 12 months. However, this trend might be about to change.
Aninda Mitra highlighted that carry trades would “probably come under pressure if the yen appreciates from here by 2-4%. If your carry expectation was a 5-6% return versus the yen, then clearly that starts to erode.” Nonetheless, the yen continues to serve as a funding currency because Japanese yields remain much lower than those elsewhere.
“The carry trade is going to become less profitable. You’re mining the riskier a bit of the of the seam of gold,” said Kit Juckes, head of FX strategy at Societe Generale, who expects any yen appreciation to be gradual. He added, “But for now, you kind of feel it’s still worth it.”
Muddling Through
Predicting the impact of the BOJ’s policy shift on markets becomes more challenging due to the complexity of the new policy and investors’ understanding of it. James Malcolm, head of FX strategy at UBS investment bank, expressed his concerns, “They’re essentially digging themselves a deeper hole in terms of making it very, very difficult for the market to take away simple things. They’re trying to control too many variables. It’s a very difficult concept to get across to anybody who’s not willing to spend an awful lot of time and effort following it.”
Overall, the recent policy change by the Bank of Japan has set the Japanese yen on a turbulent journey towards strengthening. This shift threatens the carry trade strategy and has implications for global markets. As the yen becomes more expensive, the potential impacts on risk assets and investors relying on carry trades are significant. While the full extent of these consequences remains unclear, it is evident that the volatility in yen trading is just the beginning of an eventful period in the financial world.
