The Japanese Yen and the resumption of the carry trade

It seems that last month's G7 intervention was the turning point for the Japanese Yen. The Group Of Seven Industrialized nations stepped in the currency markets on March 18th in order to halt the Japanese yen rise. The coordinated intervention occurred after the yen soared following a massive earthquake, tsunami and nuclear disaster, which struck Japan last month. Speculation the Japanese would liquidate their overseas assets and repatriate their funds for reconstruction triggered a demand for the yen pushing it up to record highs.

The appreciation of the yen created a difficult situation for the Bank of Japan as it could further damp the country's economy, as well, as the global recovery. Japan is a country heavily relying on exports and a strong yen may hurt the country's economy risking a fall back into recession.

As investors' risk appetite begins to heal, the phenomenon of the carry trade begins to re-emerge. A carry trade is a trading strategy where an investor borrows low yielding currencies such as the Japanese yen in exchange for higher yielding currencies such as the Australian dollar. Ultra-low interest rates in Japan provide the ideal condition for investors who want to borrow yen and invest in currencies that offer higher interest rates. The purpose of the carry trade is to earn from the interest rate differentials of the two currencies. The following example will provide a clearer picture on how a carry trade in the fx market works. Suppose you have 1000 Australian dollars and you want to buy the AUDJPY. In the currency markets you earn interest on the currency you buy and you pay interest on the currency you sell (borrow). Thus, buying the AUDJPY pair means that you will earn 4.75% per annum holding Australian dollars and pay 0.25% borrowing Japanese yen. If you buy 100000 Australian dollars using 1:100 leverage you will earn 4.5% interest on that amount, which is about 4500 Australian dollars.

EURJPY and AUDJPY recent gains are due to the return of the carry trade. The Australian dollar is one of the highest yielding currencies of the developed world with 4.75% interest. Investors sold then yen to invest in Australian dollars pushing the pair to a two and a half year high at 90 yen. Also, the yen plummeted against the euro and the pair reached an eleven month high at 123.31 from as low as 106.65.

Fundamentals add further to the view that the carry trade has resumed. The Bank of Japan appears determined to support the country through its crisis by maintaining a super-loose monetary policy. In contrast, world major central banks look ready to tighten their monetary policies. The European Central Bank raised its benchmark lending rate by 25 bps to 1.25% and speculators argue that more rate hikes will follow. Also, The Bank of England is expected to hike their interest rates in May and the Fed is expected to finish its Quantitative Easing program in June. As interest rate differentials between Japan and the rest of the G7 countries are expected to widen, the carry trade is expected to resume.