A blistering rally in the Japanese yen ahead of an expected interest rate hike from the Bank of Japan next week is upending the long-established and lucrative carry trade, as investors rethink the path ahead for the volatile currency.
Early hints of capital repatriation and expectations of a faster pace of monetary tightening by the BOJ along with U.S. pressure are combining to boost the yen, which hit 40-year lows in July, triggering a joint U.S.-Japan intervention.
The spike is also spurring an unwinding of the popular carry trade, which involves borrowing yen at a low cost to invest in other currencies and assets offering higher yields, as traders brace for central bank meetings in Japan and the U.S.
"The carry trade is vulnerable because this unwind is happening before the BOJ has even delivered its expected hike," said Charu Chanana, chief investment strategist at Saxo.
"Some yen shorts have already been cut, but positioning still looks sizeable, so further yen strength can turn a gradual reduction in leverage into a much faster, self-reinforcing unwind."
While the true size of the yen carry trade is difficult to pin down, analysts have parsed through data that shows a significant amount of money is tied up in the trade and could jolt markets if unravelled suddenly like in August 2024.
Cross-border yen borrowing - a proxy for the carry trade - ballooned to a record 360 trillion yen ($2.35 trillion) as of March, according to a Jefferies analysis of data from the Bank for International Settlements, making it the largest carry-trade build-up of the past three decades.
Assuming that Japanese Prime Minister Sanae Takaichi would be able to continue loose monetary policy along with her fiscal stimulus, "the yen carry crowd took on excessively large positions and the unwinding of those positions is now accelerating," said Akira Moroga, Aozora Bank's chief market strategist.
The yen firmed to its strongest level since February at 152.89 per dollar on Tuesday, in a quick reversal of fortune for the currency that was loitering at around 160 less than a week earlier, stoking worries about another bout of intervention.
"The break below 155 appears to have triggered another leg of yen short covering, with both leveraged funds and real-money investors reducing short-yen exposure," said Masahiko Loo, senior fixed-income strategist at State Street Investment Management in Tokyo.
The dramatic surge points to stop-loss orders - automatic instructions to buy or sell once a currency reaches a pre-set level - being triggered around certain levels that accelerated the move in the dollar/yen, analysts said.
The move was broad-based with the yen marching almost 5% higher so far in September against the usual carry trade favourites: the Mexican peso and the Turkish lira.
"A further unwind could push USD/JPY toward the mid-140s given the sizeable outstanding short position," Loo said, noting that investors are increasingly pricing a more hawkish BOJ path. "That said, this is no longer just a positioning story."
At present, the odds stand at 97% that the BOJ will raise its key rate by 25 basis points to 1.25%, according to Tokyo Tanshi data, up from 52% a month ago. The figures show a 27% chance of a rate increase in October and 61% odds in December.
Traders wary of 2024 echoes
The stakes of a disorderly unwinding were laid bare in 2024, when a BOJ rate hike sent the yen higher, forcing traders to abandon their carry trades and sending shockwaves across the global markets for days.
But analysts say this time is different as investors are bracing for a sustained hawkish follow-through from the Japanese central bank and are unlikely to be surprised - having learned their lesson.
Kenneth Goh, UOB Kay Hian's director of private wealth management, said in 2024 the yen rallied and there was nowhere for the money to go.
"That is what has changed. Money no longer has to leave Japan to earn a return," Goh said, pointing out that the 10-year Japanese government bond yield has been hovering near its highest point in 30 years.
"Whether this is a turn or another squeeze gets answered after September 18, not before it. If the yen holds its gains after a hike, the funding side has genuinely repriced."
To be sure, the fear today is that expectations are perhaps too high for BOJ Governor Kazuo Ueda to meet and disappointed market participants could just as rapidly drag the yen lower.
Citi's FX sales desk said market expectations are running too high as the BOJ is unlikely to want to repeat the summer of 2024.
"That said, in a world where every meeting is genuinely 'live,' I would expect the type of carry trade in which investors simply stay short JPY 'until the next hike meeting' to shrink," it said in a note.
For now, traders are choosing to retrace their steps as the pivotal central bank meetings next week could dictate the fate of the yen and the carry trade.
"Many traders remain reluctant to aggressively rebuild yen shorts given the intervention risk," State Street's Loo said. "The carry trade still works, but it is no longer a free lunch. It now comes with a political risk premium."
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