The Bank of Japan Reaches for the "Rate Hike Knife"

This summer marked a significant downturn in global financial markets, attributed to the unwinding of yen-carry trades. Over a mere span of three weeks, approximately $6.4 trillion was erased from global stock prices, with the Nikkei 225 experiencing its steepest single-day drop since 1987. The ripple effect of this market upheaval left an indelible mark on traders, many of whom still contend with the memories of those tumultuous days.

As we approach the end of the year, market observers have begun to notice unsettling similarities to the conditions that precipitated the summer sell-off. Yen-carry trading, which involves borrowing yen at low interest rates to invest in higher-yielding currencies or assets, appears to be regaining traction. Alarmingly, there are signals that the Bank of Japan (BoJ) might soon raise interest rates, reigniting fears of another market meltdown similar to the one experienced in August.

The essence of yen-carry trading lies in its strategic play on interest rates. Investors capitalize on the disparity between Japan's negligible borrowing costs and the significantly higher rates available in markets like the United States or Mexico. This strategy has thrived in the low-rate environment provided by the BoJ. However, if the trades come under pressure and investors are forced to repurchase yen, this could lead to a cascading sell-off of risk assets previously acquired.

In recent weeks, evidence suggests that yen-carry trades are gaining renewed popularity. According to data from the Japan Financial Futures Association, the Tokyo Financial Exchange, and the Commodity Futures Trading Commission (CFTC), net short positions in yen held by retail investors and foreign hedge funds have surged from $9.74 billion in October to $13.5 billion in November.

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Analysts point to several factors fueling this resurgence: the widening interest rate differentials, increased government borrowing in the United States, and relatively low volatility in the currency markets. Such conditions make borrowing in yen for high-yield investments globally an attractive proposition. Strategists at companies like Mizuho Securities and Saxo Bank anticipate that the scale of these carry trades could soon rival the levels seen early this year.

The driving force behind yen-carry trading has historically been the divergence in interest rates. The average yield on G10 currencies and ten classes of emerging market high-yield currencies has risen to over 6%. In stark contrast, Japan's benchmark borrowing rate remains a paltry 0.25%. Even with local bank loan rates hovering around 1.7%, the cost of borrowing yen remains considerably low.

Despite the BoJ’s gradual move to lift interest rates, the yield gap between Japan and other major economies remains substantial. This means the potential profits from yen-carry trading are still quite lucrative. Since the end of 2021, carry trade returns targeting major and emerging market currencies have soared by 45%, outpacing the 32% returns of the S&P 500 when accounting for dividends.

The lucrative nature of these trades has drawn an increasing number of investors. Prior to the mass unwinding in July — when yen-carry positions were cut back significantly — net short positions swelled to an impressive $21.6 billion. Alvin Tan, head of Asian foreign exchange strategy at the Royal Bank of Canada in Singapore, noted that the absolute interest rate differential between other currencies and the yen is vast, ensuring that the yen will continue to be viewed as a preferred funding currency.

However, it’s essential to note the significant pressures the yen is currently under, stemming from structural issues such as capital outflows. This year, the yen has performed the worst among G10 currencies. Even though it reached levels around 140 against the dollar during the unwinding of the carry trades a few months ago, it has now weakened to the vicinity of 150.

Concurrently, there looms a risk that the resurgence of yen-carry trading could soon face a challenge: the possibility of the BoJ raising rates at the end of the year. An uptick in rates could trigger the same chaotic sell-offs witnessed over the summer.

Last week, a sudden spike in the yen underscored the ongoing risks faced by new entrants into the carry trading landscape. Market participants now worry that narrowing interest rate differentials could lead to diminished carry trade activity next year, especially with BoJ Governor Kazuo Ueda hinting at a December interest rate increase.

Japanese officials have also expressed concern about the recent trend of yen depreciation, with the Finance Minister noting sharp volatility since late September. The BoJ is set to announce its interest rate decision on December 19, shortly after the Federal Reserve’s own announcement. Many analysts expect the BoJ to raise rates by 25 basis points to 0.5%, signaling its third policy tightening within a single year for the first time since the asset bubble burst in 1989.

In an interview segment released last week, Governor Ueda suggested that "they are nearing" the point of considering another rate hike, citing positive trends in economic indicators. Meanwhile, Jane Foley, the head of foreign exchange strategy at Rabobank in London, noted that the market is buoyed by expectations of a potential rate increase in December, with the implication that the central bank will wish to meet those expectations without disappointing investors.

Considering the backdrop of the massive unwinding of yen-carry trades in August following the BoJ's tight policies comprising rate hikes and quantitative tightening, the potential impact of any forthcoming interest rate increases could be severe. It raises the question: will the central bank’s actions once again lead to turbulent market conditions?

Foley also pointed out that the Japanese Finance Ministry is reengaging with speculators through verbal interventions. The ongoing commentary from the BoJ governor continues to stir concerns about a December interest rate increase. Hence, while carry trades are seeing renewed support, confidence and momentum may wane in the lead-up to spring of next year.

That said, the uncertainty around the ultimate monetary policy stance of both the BoJ and the Fed means it is too soon to declare a definitive end to carry trading. The forthcoming meetings in December could provide investors greater clarity. Should the BoJ approach rate hikes dovishly or the Fed take a hawkish stance on rate cuts, it may leave room for yen-carry traders to remain active in the market.

Ultimately, Shoki Omori, chief strategist at Mizuho Securities’ Japan division, expressed that the BoJ’s approach to hiking rates would likely be slow. If Federal Reserve Chairman Jerome Powell does not opt for rapid cuts, the prevailing interest rate differentials could remain attractive for carry trading. Investors will be closely monitoring these developments for the foreseeable future.