Mr. Kazuo Ueda, Governor of the Bank of Japan

With the Bank of Japan, the only G10 central bank not to have hiked policy rates, it seems that all the carry-trade activity has been pushed into the yen, forcing its huge fall against other currencies. But could we see a boomerang trade once the BoJ starts to normalise policy?

The first thing to bear in mind about the FX market in Japan is that it is unlike most others given the high prevalence of retail trading, or the Mrs. Watanabe’s as it has been called for some time to reflect the image of the lone retail trader. Such retail traders seemingly don’t just trade for fun, but because yields have been so low in Japan for such a long period of time that they want to earn the pick-up from buying higher-yielding foreign currencies.

And it is not just the Mrs. Watanabe’s that do this; other traders and investors in bigger firms clearly also take part. Evidence seems to suggest that this activity has increased significantly through the rate-tightening cycle. For instance, if we look at data from the CFTC on yen positioning, we see large short positions by non-commercial traders. Data from the Tokyo Financial Exchange (TFE) gives an even clearer picture of largescale long positions in high-yielding emerging market currencies, especially the Mexican peso, and short positions in the yen.

In short, it seems that the overseas rates on offer are just too good to resist even if relatively high yen volatility is weighing on the carry-to-risk ratios. While the attraction of holding higher-yielding foreign assets on an unhedged basis might have risen (notwithstanding the rise in yen volatility), the returns from yen-hedged positions have gone the other way because the cost of hedging has risen so much.

For instance, while 10-year treasuries yield some 340-bps more than 10-year JGBs, a 3mth rolling hedge of the currency risk leaves Japanese yields more than 200-bps over treasuries. This unattractiveness of hedged foreign asset holdings may well have forced many investors who would not normally leave currency exposure unhedged to eschew their currency hedges, so adding to the downward pressure on the yen.

The key question now is what happens when, and if, the Bank of Japan reverses policy and so makes the yen a less attractive currency for the carry trade. It could mean a double whammy, for if the BoJ is tightening and so lifting funding costs for the carry trade, central banks on the other side of the ledger, such as the Fed and SARB could be reducing the return from the investment currency by cutting their policy rates.

Now it seems very unlikely that the BoJ will conduct some sort of sudden volte-face on its policy, certainly at this stage. But that’s not really the point. For the crucial issue is whether baby steps to such a reversal via, for instance, a tweak in the yield curve control (YCC) policy at this Friday’s meeting could spook the market so much that a dramatic reversal of yen carry-trade positions follows and so lifts the yen materially. Now judging by what we saw last time the YCC was tweaked in December it would seem that the answer is “no”.

However, this did not come long after hefty BoJ intervention last September to strengthen the yen. The fact that the yen rose by nearly 6% in trade-weighted terms in Q4 last year suggests that many carry traders had exited positions before the BoJ tweaked its YCC policy on December 20th. This meant that market positioning was reasonably balanced and hence the yen did not rally even further in spite of the YCC change. Contrast that with today, where we suspect that the vulnerability of carry traders to a surprise tweak in the YCC is much greater than it was in December.

“If the BoJ were to allow 10-year JGB yields more licence to roam higher this Friday, we suspect that it could push dollar/yen down into the mid-to-low 130’s pretty quickly, with other yen crosses moving in tandem. Of course, we don’t know that the BoJ will tweak its policy; the odds seem to be against it but, as we’ve said many times before, to be forewarned is to be forearmed”, said Mr. Mr. Steve Barrow, Head of Standard Bank G10 Strategy.