Introduction
For many years, investors have actively engaged in the carry trade between the Japanese yen (JPY) and the US dollar (USD), capitalizing on the differences in interest rates to secure profits. The typical strategy involved borrowing JPY at very low-interest rates, thanks to Japan's long-standing monetary policies, and then investing those funds in USD, where interest rates were significantly higher. This approach allowed investors to earn a favorable return on their investments due to the interest rate differential between the two currencies. However, recent shifts in the monetary policies of both the Bank of Japan and the Federal Reserve have altered the dynamics of this strategy. This article will explore the current perspectives on the JPY-USD carry trade, examining how these policy changes impact its profitability and the following activities of the BOJ.
Historical perspective
Japan has grappled with economic challenges for several decades, with deflation being one of the most persistent and problematic issues. Deflation, a condition where prices continually decline, has deeply affected the Japanese economy. When prices fall, consumers and businesses tend to delay spending and investment, anticipating that goods and services will become even cheaper in the future. This behavior further suppresses economic activity and growth.
Source:https://web-archive.oecd.org/2022-09-06/640037-consumer-prices-oecd-updated-6-september-2022.htm
To fight deflation and boost the economy, the Bank of Japan (BOJ) has kept interest rates very low for many years.They also implemented a monetary policy known as quantitative easing. This strategy involves the central bank increasing the money supply by purchasing large quantities of government bonds and other financial assets. By doing so, the BOJ aimed to lower interest rates and increase liquidity in the financial system, thereby encouraging lending, spending, and investment. The influx of capital was intended to stimulate economic activity and counteract deflationary pressures, ultimately fostering higher inflation and economic growth.
However, despite these efforts, Japan's economy hasn't experienced the anticipated level of growth. A significant factor contributing to Japan's economic stagnation is its aging population. Japan has one of the oldest demographic profiles globally, resulting in a shrinking workforce and reduced consumer spending.
Furthermore, the decrease in the working-age population has led to increased expenditures on healthcare and other social security programs, as a larger proportion of the population requires medical care and pension support. This demographic shift places additional fiscal pressure on the government and strains public resources, complicating efforts to stimulate economic expansion.
Another critical issue is the relative lack of structural reforms in Japan's economy compared to other advanced nations. Specifically, Japan has not sufficiently addressed barriers to female labor force participation or the integration of immigrant workers into the economy. Policies and societal norms continue to make it challenging for women to engage in full-time employment, limiting the potential labor pool and economic productivity. Additionally, stringent immigration policies have hindered the inflow of foreign workers, exacerbating labor shortages and impeding economic dynamism.
Because of these challenges, the BOJ has started to make changes. They are not being as expansive as before, meaning they're not printing as much money or keeping interest rates as low.
USDJPY
The US dollar continues to appreciate against the Japanese JPY, despite the intervention of the BOJ that in the week of 29 April 2024 dropped the exchange rate after the peak at 160. The decline, however, stopped in area 152, technical level that the market saw first as resistance (October 2022 and November 2023) and now as support.
The current monetary policy environment does not seem to be conducive to a recovery of the Japanese yen; if on the one hand Powell, at a press conference on 1 May 2024, confirmed that until the FED sees a concrete return of inflation close to the 2% target it will not start to cut rates (Reuters), at the same time the BOJ did not provide forward guidance on its policy of raising interest rates, despite identifying the level of 160 yen per dollars as a "final defence line" (Reuters).
The lack of clear forward guidance on interest rates by both central banks is not playing into the hands of the spread between 10-year Japanese and US yields. The spread is in fact close to the lows of recent years, around the level of -340 bps in June 2024, which means a differential of 3.4% between the US dollar and the Japanese yen. The opportunity to carry trade between JPY and USD remains one of the most interesting trades in 2024.
The JPYUSD carry trade will therefore remain attractive until the FED and the BOJ change course in their respective monetary policy choices, but this does not seem to happen by 2024. Indeed, the spread between the YoY growth rate of US GDP compared to Japan GDP remains high, at 3.2%. As long as US GDP grows to 3% a year (with inflation close to 3%) and Japanese GDP remains around 0% (with inflation close to 2%), it is difficult to assume a more dovish FED and a more hawkish BOJ.
The futures on FED rates maturing in December 2024 indicate an interest rate of around 5% by the end of the year, thus discounting just two rate cuts of 25 bps, from the 6/7 discounted cuts at the beginning of 2024. At the same time, futures on Japanese rates do not indicate any expected increase between now and the end of the year, confirming the scenario described above.
In summary, the most famous carry trade should generate attractive returns with low risks until the end of the year, ceteris paribus.
BOJ ACTIONS
In order to prop up the yen, data suggested the BoJ had supposedly spent 5.5 trillion yen (35 billion USD) using their foreign reserves. This doesn’t come as a surprise as the yen hit a 34-year low at the end of April. The data in question comes from the BoJ’s projection for the money market conditions which indicated a 5.6 trillion yen credit in their current account. And it worked, the yen surged to around 153 to days later.
Until the end of May the amount actually spent was all a ballpark figure and government officials refused to explicitly state whether they intervened or not. But why the secrecy ? The Ministry of Finance was worried about the potential free fall of the yen due to speculations. Ambiguity was needed so that traders wouldn’t push the yen beyond certain thresholds which further extends the effect of the intervention
Finance Minister Suzuki’s office officially revealed that they actually spent 9.8 trillion yen (62.7 billion YSD) between April 26 and May 29. In order to maintain the yen hovering around the 156 level. This is not the first time Japan has spent this much in order to prop up the weakening yen. Back in October 2022 Japan spent around $42 billion USD when the yen traded for 148.
The difference between the reactionary measure is that after the 2022 spending, the yen appreciated up to 128 in the following months and it took about a year to reach back to the 148 levels. However, a month later after the current spending we’re back at the 157 levels.
Obviously, such spending is unsustainable for the BoJ to continue on doing. Moreover, Japan can’t always resort to the currency intervention as she has commitments to her G7 partner countries as well. Which is mainly why there was a gap of around 1.5 years between the two currency interventions.
Japan has now, as mentioned before, set its sights on the 2% inflation target. How Japan handles the yen will be definitely a factor on how the elections will play out on October 2025 as the people are already feeling the inflation and stagnation of wages.
Despite the repeated interventions of the BOJ and the desire of the BOJ to support the Yen, hedge funds and asset managers continue to bet on the downside, as shown in the chart below.
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