Analysis: Yen faces sustained slide from carry trade revival

By Natsuko Waki and Hideyuki Sano

TOKYO (Reuters) – A revival in yen carry trade is set to place the Japanese currency on a sustained slide as the Bank of Japan keeps printing money at a time when central banks in the euro zone and the United States move closer to lifting interest rates.

The BOJ is becoming the last of major central banks to unwind its super-loose policy, keeping yen interest rates near zero and lagging the rise in rates elsewhere.

This rekindles the yen’s use as a funding vehicle, a role the currency played from 2005 until the 2008 financial crisis when the carry trade — selling low interest-rate currencies to fund high-yielding investments — collapsed.

Coordinated FX intervention on March 18 by major central banks has shown that authorities are determined to act to stem a rapid yen rise, making investors nervous about pushing the currency higher.

Higher U.S. yields will make the dollar less attractive as a funding currency and are likely to prompt Japanese institutional investors to unwind currency hedges on their hefty overseas bond holdings, a shift that should give the dollar a boost.

Moreover, import needs for energy and resources to rebuild northeastern Japan devastated by the March 11 earthquake may lead to yen selling pressure and even trade deficits for Japan.

“The current risk environment is preventing the dollar/yen from tracking interest rate differentials, but the relationship could strengthen again in the medium term and upward pressure on the yen is likely to recede,” said Masafumi Yamamoto, chief currency strategist at Barclays Capital.

Investors also scaling back expectations that Japanese investors would repatriate their overseas funds en masse after the quake — a factor that drove the dollar to a three-week high of 83.16 yen on Wednesday, up 9 percent since its record low of 76.25 set on March 17.

The dollar faces heavy chart resistance in the near-term, but a move above 85.94 yen — the high reached during Japan’s one-day bout of solo intervention last September — would put it on a path toward a sustained rise.

The higher-yielding Australian dollar has risen more than 14 percent from pre-intervention lows, a move that reinforces the yen’s regaining its funding status.

One key sign that interest-rate differentials are playing a greater role and should help drive the dollar higher: the correlation between U.S.-Japan interest rate spreads and dollar/yen is reestablishing its traditional strength.


Hawkish comments from Federal Reserve officials this week are raising expectations the Fed would kick off its tightening cycle as early as later this year. The two-year Treasury yield has hit a 3-week high at 0.825 percent.

In contrast, comparable Japanese yields have dipped to 0.205 percent as banks park funds in short-term paper after the BOJ’s post-quake fund injections.

As a result, the U.S.-Japan two-year spread has reached 62 basis points, compared with around 33 bps on March 16 and a record low of 20 bps reached last year.

The yen and U.S.-Japan yield spread have historically enjoyed close relationship, suggesting wider yield spreads will help push dollar/yen higher.

The average weekly correlation since 2005 stands at 0.45. Over the past 12 weeks it has gone up to an above-average 0.49 after having broken down to -0.12 — showing a rare inverse relationship — toward the end of September.

According to Morgan Stanley’s calculations, if the impact of a 1 percentage point widening in the two-year yield spread were as great as 2006 levels — 6.56 percent — the yen would fall to 97.2 by 2012.

“This widening of the two-year spread alone would be enough to lift dollar/yen to our end-2012 target to 98, provided that the interest-sensitivity of the cross remains close to that observed over the past five years,” the bank wrote in a note.

In the euro zone, policymakers have made it clear that interest rates would rise next month, becoming the first G7 central bank to tighten policy this year.

Three-month EURIBOR, or euro-priced interbank lending rate, has risen as high as 1.231 percent, levels not seen since June 2009. And the has broken out of its range to a 10-month high of 117.27 yen.


The after-effect of Japan’s triple disaster of earthquake, tsunami and nuclear emergency means resource-deficient Japan would need to import more — from construction materials to energy sources — to rebuild.

This would help narrow or even wipe out Japan’s trade surplus, relieving upward pressure on the yen. The country’s trade balance has already been flirting with deficit on a monthly basis for some time.

“If a recovery in production capacity in key domestic manufacturing facilities is delayed and an export recovery is also slowed, there is a possibility for the trade balance to narrow more than expected,” said Hiromichi Shirakawa, research analyst at Credit Suisse.

The yen-selling trend could also accelerate as domestic institutional investors are likely to lighten their currency hedges by buying back dollars and retail investors may resume their investment in high-yielding overseas assets once the risk environment stabilizes.

In the October-March half year, most Japanese life insurers have expected the dollar to bottom around 75-80 yen. Some big investors, including the top insurer Nippon Life, have said it might increase unhedged bond holdings if the yen levels are favorable.

(Additional reporting by Reuters FX analyst Rick Lloyd; Editing by Eric Burroughs and Ramya Venugopal)

Analysis: Yen faces sustained slide from carry trade revival