USD/JPY - is the carry trade losing momentum?

The Bank of Japan (BoJ) has continued its loose monetary policy and allowed the Japanese yen to depreciate to a 24-year low against the US dollar.

According to an article in the Financial Times, Haruhiko Kuroda, governor of the Bank of Japan, was confident that Japanese households had become more “tolerant” of increasing prices food and energy prices – comments he was later forced to retract. Kuroda held firm with rock-bottom interest rates, in contrast to western central banks that are taking aggressive steps to combat inflation.

Bloomberg quotes the chief economist at Japan’s leading Bank MUFG: “Kuroda is firmly and clearly saying that he will not cave into the intensified market pressure. By just sticking to his goal of stable inflation, Kuroda is demonstrating a rock-solid determination to continue easing.” This situation puts market pressure on the yen and Japanese government bonds.

What is a carry trade and why is it so important?

The Cambridge Dictionary defines a carry trade as “a method of investing in which an investor borrows money at a low interest rate to buy an investment that is likely to produce a much higher amount of profit”. In currency markets, this means that investments in countries with low interest rates flow into countries with comparably higher interest rates.

Japan introduced zero interest rates in 1999 while emerging from a catastrophic real estate bubble burst. As a result, for decades the Japanese have invested in foreign currencies and countries that give them a better yield.

Since January 2021 alone this has lead to a rapid depreciation of the USD/JPY from a low at 102.59 to 136.99 by 26 June 2022. The move was most pronounced since the end of May 2022, when the USD/JPY quickly advanced from 126.85 to its current record levels. This was largely driven by the strength of the US dollar. The US central bank acted aggressively in their efforts to increase interest rates, creating an ever-bigger interest rate differential between the US and Japan.

With companies and families increasingly feeling the inflation pinch as a result of rising energy and food prices, the Bank of Japan is now under increasing pressure to review its policies and consider its monetary position. Any change has the potential to affect the markets in a significant way as a change in Japanese monetary policy is not priced in by the markets.

What would be market impact of a change in monetary policy at the BoJ?

The big question for investors and speculators is how to benefit from the opportunity if the BoJ was to change its monetary policy. The Swiss Central Bank surprised the markets on 16 June 2022 by raising its interest rates by 50 basis points. This decision caught the market off-guard and has sent shock waves through the global financial markets. The Swiss Franc strengthened immediately.

However, the Swiss capital market is insignificant compared with Japanese capital markets. Any decision from Haruhiko Kuroda to increase interest rates in Japan could lead to a massive re-shifting of capital and, as a result, inject strength into the JPY, moving it back from current USD/JPY record levels.