Since Japan's economic crash in the 1990s, the Bank of Japan (BOJ) has maintained extremely low interest rates to combat deflation. For nearly a decade, Japan's benchmark rate has been negative, contributing to a deflationary economy. Consequently, the US Dollar-Japanese Yen (USD-JPY) carry trade has been popular for the past 30 years.
This trade involves borrowing Japanese Yen at very low or negative interest rates and investing in higher-yielding US dollars or dollar-denominated assets. The trade performs well under conditions of low forex market volatility, a gradually weakening Yen relative to USD, and negative interest rates in Japan paired with higher rates in the US, creating a wide interest rate spread. These conditions have prevailed over recent decades. As seen in the chart below, the strategy has been increasingly profitable over the last 10 years. However, three significant periods challenged its profitability:
Period 1 | January - September 2016
BOJ Governor Kuroda announced a negative interest rate policy (-0.1 percent on certain bank reserves). Despite this, the Yen appreciated 17.54 percent from January to August 2016, causing the trade to unwind. However, the Yen ended the year only 3.46 percent higher, and anticipation of a US rate hike reinstated the trade's attractiveness.
Period 2 | October 2022 - January 2023
The Fed aggressively raised rates while the BOJ maintained loose monetary policy. The wide rate spread and JPY/USD at a 32-year low made the trade attractive. However, the BOJ's widening of the yield curve control band led to a 14 percent Yen appreciation in two months. Global recession fears and China's ending of zero-COVID policy caused market uncertainty and risk-off sentiment, further unwinding the trade. By late January, recession fears eased and global markets stabilized, while the US-Japan interest rate spread remained wide, allowing the carry trade to regain higher levels of profitability.
Period 3 | Recent months
Since July 10th, the Yen has appreciated 9.98 percent against the dollar, while the BOJ has taken a hawkish approach, evidenced by a recent rate hike. Anticipation of a Fed rate cut has triggered a yield-driven unwind. Poor US tech earnings and a subsequent market selloff exacerbated the situation.
The global Yen carry trade is estimated at $1 trillion. As of August 13th, futures positions are net long on JPY for the first time since 2021, signaling an unwinding as traders bet on Yen strengthening. With recent tech drawdowns (where much carry trade capital was invested) and Yen appreciation, the USD-JPY carry trade is being squeezed on both sides. Given the trade's global scale, we believe a sustained decrease in USD-JPY carry trade positions is likely as traders dispose of short Yen exposure.
