Carry trade is a strategy which involves taking a short-position in a low-interest currency (funding currency) and simultaneously a long-position in a high-interest currency (target currency). The interest rate differential, however, is not the only determinant in such a trade. Currency risk or the expected movement in the exchange rate is a weightier consideration for the trade participants.
Prior to financial crisis (2008), the yen had been the most favoured funding currency amongst the investors primarily due to the protracted period of low interest rates in the Japanese economy since the mid-1990s. Some of the preferred target currencies were the Australian/New Zealand dollar, Mexican peso etc. The period following the financial crisis (2008) saw the reversal of the Yen carry trade as the US dollar replaced the traditional funding currency owing mainly to historically low levels of interest rates in the US economy. Although interest rates in the US had been low during 2004-07, they were still higher than those prevailing in Japan. It was after April 2009, that the short-term interest rates in the US fell below that of Japan.
The flight of hot money from the US to China is one instance of the carry trade flow triggered by the policy measures adopted in the period following the 2008 crisis. Moreover, steady appreciation of the Chinese Yuan against the US dollar since April 2008, ensured sustenance of this trade. The USD/CNY trade, however, may not be sustainable anymore given the recent decision by the Fed to withdraw the monetary stimulus in a phased manner along with an expected devaluation in Yuan.
With the US economy showing signs of revival and the decision by the Fed to taper the monetary stimulus in increments of $10 billion before ending them in October 2014, the interest rates in the US are expected to rise in the near future. Meanwhile, Abenomics has been the economic norm in Japan ever since Shinzo Abe assumed the position of the Prime Minister in December 2012. One of the crucial components of this discipline has been a highly explosive monetary stimulus undertaken with the twin purpose of ending deflation and weakening the Yen. The Fed’s decision to trim the asset purchases coupled with the likely extension of Abenomics in Japan may pave the way for the JPY/USD carry trade in the near future.
The latest statistics on interest and exchange rates also indicate a likely resumption of the JPY/USD carry trade. Although the short-term interest rates in the US are just above that in Japan, long-term interest rate spread between the two countries has widened to more than two percentage points of late [figure 1a) and 1b)]. There has also been acceleration in interoffice assets of foreign banks in Japan which have increased from 6.7 trillion yen in December 2012 to 8.2 trillion yen in January 2014 (fig.2). Although interoffice lending is not the only representative of ‘carry trade’, it can be considered as one of the suitable proxies. Since, carry trade is not without inherent exchange rate risks, it is important to consider the JPY/USD trend in the past few years. The yen has exhibited a depreciating trend against the US dollar since December 2012. The average rate of yen against the US dollar was 79.8 in 2012 while the corresponding figure for 2013 was 97 and the signs of depreciation continue in 2014 evident from the latest monthly data. USD/JPY rate was 102.02 in February 2014.
Figure 1a) Short-term interest rates in the US and Japan (%) Figure 1b) Long-term interest rates in the US and Japan (%)
Figure 2 Interoffice lending of Foreign Banks in Japan
(100 million yen)
Source: ECB, OECD Financial Statistics and Bank of Japan statistical database
USD/JPY data is, however, vulnerable to correction as a lot depends on the future US economic data. Though the latest statistics on jobless claims and factory output in the US seems positive, other economic surprises and global uncertainties also need to be controlled for. For instance, the Russia-Ukraine conflict has spurred the flight of capital back to the safe haven due to which there has been appreciation in the Yen. There is also some evidence of repatriation of capital by the Japanese investors who have switched to other assets within the domestic markets. When the data on interest differential and the exchange rate of the JPY vis-a-vis the USD is considered in isolation (with other things remaining constant), there is a high likelihood for the Yen to emerge as the most preferred funding currency in the coming months.