Don't underestimate the potential of the yen carry trade
The carry trade is back in fashion, with the yen, the traditional funding currency of choice, at its heart. And history suggests it has a lot further to run.
The carry trade should not exist, according to academic theory. Uncovered interest-rate parity predicts that high-yielding currencies should depreciate, but that has failed repeatedly over the years thanks to the momentum of the carry trade. There are a number of factors that have helped the yen embark on downtrends against a raft of currencies since the start of the year, pushing yen crosses, such as NZDJPY and AUDJPY, sharply higher.
Weak Japanese trade figures have posed questions about a persistent source of structural strength for the yen, while improving risk appetite has seen investors square up safe-haven bets on the currency. The Bank of Japan’s unexpected decision to boost its quantitative in February also weakened the yen’s cause.
However, as Neil Mellor, FX strategist at Bank of New York Mellon, points out, the key ingredient of any carry trade is momentum – something that makes the trade self-fulfilling and robs the academics of their uncovered interest-rate parity theory.
It would appear that the carry trade has found that momentum, as hopes over the pace of the global recovery have heightened.
“The current uptrend in the JPY crosses speaks volumes about the prevalent market mood,” says Mellor. “For the first time in a while, investors are being buoyed by the prospect that the year-to-date rally in stock prices may have more solid foundations than just an ample source of liquidity.”
AUDJPY rise highlights longevity of the carry trade
That suggests that the carry trade could enjoy some longevity.
It is worth noting that the carry trade dominated currency markets for six years from 2001, pushing AUDJPY, for example, 92% higher. Furthermore, in its very early stages, the carry trade thrived without a backdrop of market exuberance – it took a year after the start of the tradein late 2001 before the Dow Jones Industrial Index bottomed out.
NZDJPY performance hints at carry trade revival
However, Mellor says the really interesting feature of the carry trade is not its potential longevity, but the pace it can gather.
From early July 1995, for example, AUDJPY rose 33% in a straight line in just over 10 months, while GBPJPY, CADJPY and NZDJPY put in a similar performance.
The crosses then tracked sideways for a short period before vaulting sharply higher during the next year and a half to post similar-sized gains as seen during the initial burst of strength.
That performance is worth noting now.
Since the turn of the year, the most actively traded JPY crosses have put in average gains of 16.5%, led by NZDJPY with 20.9%.
“Self-fulfilling momentum against a backdrop of growing optimism is a potentially powerful combination for the carry trade strategy,” says Mellor.
“Hence, we should not presume that such heady gains leave it closer to the end of its life than its beginning.”