For long, the yen has been the favoured currency in carry trade (a strategy in which the investor borrows in low-interest-rate (funding) currency and invests in a high-interest-rate (target) currency). However, it appears imminent that it will be replaced by the US dollar. The moot point, however, is whether this will be a permanent phenomenon.
Carry trade is not without inherent exchange rate risks. One of the exchange rate risks is the expectation that the target currency will depreciate against the funding currency to offset the interest rate differential between the two. Available evidence since the 1990s, however, suggests that the target currency has instead appreciated, thereby, yielding higher than expected profits to carry traders.
Prior to the 2008 financial crisis, the yen served as the top funding currency given the impossibly low interest rates in Japan i.e. .07 per cent and .365 per cent for 2005 and 2006 (six-month Libor) respectively (WEO database, IMF) Yen borrowers were helped not only by the higher interest rates in New Zealand and Australia, but also by the appreciation of these target currencies. However, with the onset of the sub-prime crisis and the subsequent flight to safety, investors rushed to pay back in yen, thereby, causing an upward movement in its value and a temporary demise of carry trade.
With the crisis subsiding and the global economy showing signs of recovery, it remains to be seen which of the two currencies, the US dollar or the Japanese Yen, will emerge as the stronger contender to revive carry trade. With interest rates in the U.S. near zero and a strong possibility of dollar depreciation owing to a huge budget deficit (estimated to be $1.34 trillion for 2009 by the Congressional Budget Office), the US dollar seems to possess the characteristics of an ideal funding currency for carry trade. This is not the first time that it will play the role of a funding currency. It was one of the top funding currencies during the low-interest-rate regime (from 2002 through mid 2004) in the U.S. It could, however, never dethrone the yen in this game.
Recent data, however, suggests that the dollar may replace the yen as the funding currencies. According to Bloomberg, on September 14th 2009, the three-month dollar Libor (.29 per cent) fell below that for the yen (.35 per cent) for the first time since 1993. The dollar�s claim to be the carry trade currency is strengthened by the reluctance of the newly formed government in Japan (Democratic Party of Japan) to allow any depreciation of the yen. The yen has appreciated against the dollar to 90 on Sept 24th 2009 compared to 98 per dollar on March 24th 2009 (BOJ Statistics).
Figure 1 shows the difference in the short-term interest rates for Japan and the U.S. from September 2008 onwards. It can be seen that the rate for the U.S. which was previously higher than that for Japan has fallen below the latter�s after April 2009.
Figure1:   Short-term Interest Rates (per cent per annum)
Source: OECD Financial Indicators
Figure 2 reflects the depreciating trend of the dollar from 2002 onwards followed by an appreciation after July 2008. However, there has been resumption of the downward trend in the past six months which is likely to continue until the budget deficit contracts by a substantial amount.
Figure 2:  Nominal Broad Dollar Index
Source: Federal Reserve Statistical Release
The question is whether the US dollar will continue to serve as the top funding currency in carry trade transaction for any length of time. Given the huge US budget deficit, the short-term interest rates are likely to rise in the future (Congressional Budget Office estimates). Further, the future of the Japanese economy continues to be clouded with uncertainty since the slow global recovery might fail to boost Japanese exports. Consequently, despite the Japanese government�s current stance against depreciation of the yen, it may well be forced to do so. Moreover, according to IMF estimates, Japan would continue to witness deflation till 2011. This indicates that low interest rates will continue for the next two years. Hence, it doesn�t seem likely that the dollar will displace the king of carry trade for too long.