Should You Prepare for the Yen Carry Trade Rewind?

When I first stepped into markets, the yen carry trade was hot.

Every headline, every talking head — everything — gave the Japanese yen all the credit for why investors were so excited to bury money into risk assets.

Commodities, stock markets and even high-yield currencies were the beneficiaries of the yen carry trade.

For those not hip with the yen carry trade, it’s simple …

Investors would borrow yen at low interest rates. Then they’d funnel those borrowings into investments that would return something greater than the paltry yields on Japanese government bonds.

The carry strategy is typical at banks. They earn the "spread" from borrowing at a lower rate and then lending at a higher one.

A currency carry trade targets a spread. But the dynamics are somewhat different. That’s because exchange-rate fluctuations can make or break a carry trade very quickly.

In fact, a rewind of the yen carry trade was recently smashed apart in short order. But we might soon get another opportunity to press play on another shot at a rewind.

The Japanese yen has strengthened notably in the last 11 months. That appreciation undermines the carry trade potential because it makes paying back Japanese yen borrowings more expensive.

So … what’s coming down the pike?

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Interest Rates, Interest Rates, Interest Rates

Currency carry trades materialize when the underlying currency is weakening because it is expected that it will be cheaper in the future to pay back the currency borrowed now to fund other investments.

Markets have sort of become one big currency carry trade.

Markets live and die based on current expectations for funding currencies. And current expectations for funding currencies depend on interest rates.

Above is a look at the USD/JPY exchange rate.

  As USD/JPY goes up, it indicates U.S. dollar strength relative to the yen.

  As USD/JPY goes down, it indicates Japanese yen strength relative to the dollar

For all intents and purposes, those gray and green shaded areas represent carry trades.

The USD/JPY exchange rate, like most major exchange rates, is driven by changing expectations for yield differential. That is, the narrowing or widening of the interest rate spread between two currencies.

The last 10 months of price action, however, don’t seem to reflect interest rate expectations too well.

Interest rates in Japan remain on a downward trajectory. And no one expects a change in direction anytime in the foreseeable future.

Here is an extreme depiction of the situation — a chart suggesting the entire Japanese Government Bond yield curve could soon go negative:

Meanwhile, the world is debating over whether the Federal Reserve will continue to "normalize" U.S. interest rates with more policy hikes.

Granted, expectations for interest rates in the U.S. are constantly ebbing and flowing. But we’re still staring at a pretty big contrast between the rate situation in the U.S. and Japan.

Despite the contrast, the dollar lost about 14% to the yen in the last 10 months.

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Why?

The yen carry trade — or any other currency carry trade, for that matter — is essentially a funding tool for investors.

When investors develop a healthy appetite for risk-taking, they’re naturally more inclined to borrow in order to fund investments.

You could say a carry trade and risk appetite go hand-in-hand.

And that argues for a yen carry trade revival.

Here are three thousand words’ worth of pictures to convey the risk appetite environment that appears set to drive the yen lower and the U.S. dollar higher …

First, a financial-conditions index in China is considered stimulative:

Second, it appears the same is true for emerging markets:

Last, financial conditions in the U.S. have eased dramatically thanks largely to recent U.S. dollar weakness:

Essentially, conditions are ripe for risk appetite, especially for those assets supported by economic "activity" in China and emerging markets.

Thank you, policymakers.

With financial conditions improved, the Fed will be less adamant above transmitting notes of caution. Without that trepidation, what are investors supposed to expect from the Fed but rate hikes?

Indeed, the expectations for Fed rate hikes seem to be returning now that U.S. dollar strength is pressuring, well, everything.

With that in mind, the next move for USD/JPY appears to be up (i.e., dollar strength).

Even a mere corrective bounce could lead USD/JPY more than 8% higher in the next couple months.

That’s a significant move. One that could become even more significant if "Fed normalization" becomes the order of the day and the Bank of Japan remains stuck in deflation-fighting quicksand.

At these levels, the technical picture in USD/JPY looks buy-worthy, and the market’s interest rate expectations look ripe for a U-turn.

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What to Do?

One could buy shares of the ProShares UltraShort Yen ETF (YCS).

YCS is an inverse fund that gives investors "short" exposure to the yen without having to "sell short" any shares. YCS is also designed to move twice as fast as the underlying moves in the Japanese yen.

The last great carry trade unwound amid the global financial crisis, which helped the yen surge. But with interest rates low and risk appetite returning, investors may be looking for a rewind sooner rather than later. And now is the time to get ready.

Do right,

JR Crooks

“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also …