USD/JPY: Carry trades cruise, Yen feels the heat

Major currency pairs have been stuck in a holding pattern lately, with volatility at recent lows and global equities scaling new heights. This calm environment has created a perfect storm for carry trades, particularly those funded by the Japanese yen.

For the past three years, cross-yen pairs have been on a tear, either setting record highs or reaching multi-year peaks. This trend is largely driven by the Bank of Japan’s dovish stance, which has kept interest rates negative even as other central banks have aggressively raised rates. Holding yen in this environment means earning negative returns, making it an unattractive option for investors seeking higher yields.

With volatility subdued, carry traders are enjoying the benefits of their yen-funded bets. As long as risk appetite doesn’t sour significantly, leading to a spike in equity or bond market volatility, these trades are likely to remain profitable.

Adding fuel to the fire, the Nikkei 225, Japan’s key stock index, recently surpassed its 1989 peak, further pressuring the yen as investors seek returns elsewhere. Yesterday, GBP/JPY, NZD/JPY, and AUD/JPY all reached new highs, while EUR/JPY is also on the rise. USD/JPY, however, remains rangebound. As the saying goes, don’t try and short a raging bull.

The yen’s weakness is primarily driven by interest rate differentials. The benchmark US 10-year yield is hovering near its highest level of the year, reflecting the global trend of rising rates. This further widens the gap between yen returns and those offered by other currencies, making the yen even less appealing.

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However, there are some potential risks to consider. The latest CFTC positioning data shows a significant increase in net short yen bets, the largest weekly increase since March 2021. This suggests that the trade could be getting crowded, raising concerns about a potential squeeze if sentiment shifts. Additionally, while currency intervention remains a risk, analysts say Japanese authorities are unlikely to get involved.

Overall, with low volatility and supportive fundamentals, carry trades funded by the yen seem poised to continue their winning streak. However, investors should be mindful of the potential for crowding and intervention risks on the horizon.