Currency Carry Trade—Learning the Basics

Based on a latest Bloomberg report on 08/01/2023, traders using USD/JPY pair for carry trade purposes may see big changes coming, hopefully slowly:^[7]

Seven years since Japan embarked on a highly unorthodox monetary experiment that helped pin down borrowing costs on Wall Street and beyond, the nation’s central bank is loosening its vice-like grip on domestic bond yields — with potentially profound consequences for high finance and households across the US (hint: think Japanese buyers bringing their huge pools of overseas investments back home for higher returns).

Note that this article was originally posted in 2017 for learning the basics of currency carry trade.

What is a yen carry trade? (YouTube link)

Both retail and institutional investors want to acquire an asset in anticipation of its price appreciation. However, the institutional investors is more complicated:

It is not only about the asset that is to be purchased, but it is also about how the purchase is funded. A low returning asset is a drag, but if the funding costs can be reduced, a low returning asset may still be attractive.

In the capital markets, securing cheap funding is accomplished by selling a low yielding (and ideally a low volatility) instrument and using the proceeds to purchase a higher yielding or a better performing asset.

Funding Currencies

US Dollars 

In the foreign exchange market, the dollar is the ultimate funding currency. Americans are the marginal buyer of global equities. They sell dollars and buy foreign equities, and largely on an unhedged basis. Foreign companies and countries borrow dollars and frequently convert the proceeds back to their own currency.

Japanese Yen and Swiss Franc

Besides US Dollars, levered accounts also often use the Japanese yen and/or Swiss franc as funding currencies. That is to say, those currencies are borrowed and then sold to buy another asset that is expected generate a higher yield than being paid for the funding.

Carry Trade Considerations

When a low yielding instrument is sold for an asset that is expected to offer a higher return, it is often called a carry trade. A carry trade is a trade in which one is expected to profit from the interest rate differential:

Currency carry trades materialize when the funding currency is weakening because it is expected that it will be cheaper in the future to pay back the currency borrowed now to fund other investments.

Because currency depreciation happens infrequently, many investors or speculators cannot resist the temptation of arbitraging interest rate.

Interest Rate Differential

When it comes to the value of one currency against another, short-term interest rate differentials often determine the path of least resistance for a foreign exchange instrument.^[6]

When the interest rate is higher in one currency than in another, it usually reflects a higher inflation rate in the former, which would lead to its depreciation against the latter. The interest rate difference reflects the inflation difference and the former's depreciation. 

Currency Volatility

Besides interest rate differential consideration, volatility is another factor to consider for carry trade:

• The funding currency needs to have low volatility to make a carry trade practical.
• In times of heightened anxiety or a spike in volatility, the carry trade is unwound, which is to say that the purchased asset is liquidated and the funding is replaced (bought back).

Case Study

In [2], currency expert Marc Chandler has used the following case study:

Is The Yen Or Swiss Franc A Better Funding Currency?

to make clear the considerations of a potential carry trade on 08/16/2017.

Consider that currently, one can borrow yen for about -3 bps annualized for three months. That yen can then be sold, and dollars bought and put in a three-month time deposit and earn about 130 bps annualized for the three months. One earns 133 bps over the three months adjusted for the change in the value of the yen over that period. Over the past three months, the yen has gained 2% (not annualized), which is some multiple of the carry earned.

Moreover, look a bit closer at that carry, 125 bps annualized. That turns out to be about 10.5 bps a month. This year, the dollar has moved on averaging almost 1.3% a month so far this year. On the other hand, the euro rose around 14.5% against from mid-April to early August. The carry earned is overwhelmed by the price appreciation. Some participants may have bought the euro for yen and said it was about the carry, but it was really a momentum trade.

To reiterate, the use of the Swiss franc and Japanese yen as a funding currency is not limited to the currency market, where the volatility, as we have shown, is frequently too great to make a carry strategy practical. The issue is then which currency is a better funding currency now, the yen or the Swiss franc?

The Swiss franc offers more negative short-term interest rates and is less volatile than the yen. Specifically, three-month franc LIBOR was fixed at minus 72.5 bps today. Three-month yen LIBOR was fixed at about minus three bps today. Three-month implied volatility is 7.5% annualized for the Swiss franc and 8.7% for the yen. Both countries are experiencing little price pressures. Japan's July headline CPI was 0.4% year over year, while Swiss inflation was 0.3% (0.6% in the EU harmonized methodology). The Swiss economy growth is weaker but less volatile than Japan. Japan's economy grew 1.0% in Q2 after 0.4% growth in Q1. The Swiss economy grew by 0.3% in Q1. When it reports Q2 GDP in early September, it is expected to have risen by around 0.5%.

On balance, these fundamental considerations suggest that the Swiss franc may be a better funding currency now than the yen. Technical considerations suggest some caution. The franc has depreciated by around 5% against the yen between July 10 and this past Monday. This left the technical indicators a bit stretched. Yesterday's big advance of the franc over the yen helped lift the RSI, and the Slow Stochastic has already turned up. Minor bullish divergences are evident. The MACD looks poised to cross higher before the weekend.

The cross fell into the lower end of the range seen in the second half of Q2 (~JPY112.50). A move above JPY114.30, last week’s high, is needed to confirm a franc low is in place. The JPY114.65-JPY114.75 area houses the 38.2% retracement objective of the last leg down that began on July 25 near JPY118 and the 20-day moving average. The franc has not closed above its 20-day moving average against the yen since July 21.

References

1. Should You Prepare for the Yen Carry Trade Rewind?
2. Is The Yen Or Swiss Franc A Better Funding Currency?
3. The Demise of the Dollar: Don't Hold Your Breath
• There are three basic uses for currency
• International payments
• Foreign reserves
• Debt
4. Is A Recession Coming?
• During the previous recession, the dynamics of Swiss franc was better than that of U.S. dollar and some other currencies. In that regard, CHF-denominated assets could be an attractive option.
5. The Outlook For The U.S. Dollar In 2018
• Stronger global growth and higher commodity prices are providing support to emerging market currencies.
6. The Dollar Stalls At The Highs
7. Wall Street Is Gaming Out Global Spillover Threat From BOJ Shock