BOJ rate hike: Is the Yen carry trade at risk of unwinding?

The Bank of Japan’s (BOJ) recent decision to raise its short-term policy rate to 0.5%, the highest in 17 years, marks a pivotal moment in Japan’s monetary policy. As the central bank takes cautious steps toward normalization amid rising inflation and wage growth, global markets are left pondering a crucial question: will this shift disrupt the yen carry trade?

For decades, the yen carry trade has been a cornerstone of global finance. This strategy involves borrowing in yen at Japan’s ultra-low interest rates and investing the proceeds in higher-yielding assets elsewhere.?

It has been particularly lucrative due to Japan’s historically dovish monetary policy and the yen’s persistent weakness. However, with the BOJ’s recent moves to tighten policy, the profitability of this trade may no longer be a foregone conclusion.

What’s driving the BOJ’s decision?

The BOJ’s decision to raise rates comes against the backdrop of sustained inflation and a tight labor market. Core consumer prices rose 3% year-on-year in December, well above the BOJ’s 2% target. Furthermore, recent wage negotiations have indicated that Japanese firms are willing to implement significant salary hikes, bolstering the central bank’s confidence in its inflation outlook.

However, this rate hike must be viewed in context. While 0.5% is a historic level for Japan in recent decades, it remains exceptionally low compared to other major economies. The U.S. Federal Reserve, for instance, has pushed its rates to over 5%, creating a wide U.S. Japan interest rate gap that continues to fuel the yen carry trade.

Yen carry trades: Still alive and well?

The profitability of the yen carry trade hinges on two factors: low borrowing costs in yen and a weak currency. Despite the BOJ’s rate hike, both conditions remain firmly in place. The U.S.-Japan rate differential makes dollar-denominated assets far more attractive, while the yen’s depreciation has only added to the allure of borrowing in yen.

Governor Lee Bok-hyun of South Korea’s Financial Supervisory Service underscored this point, noting that the incentive to unwind yen carry trades is currently low. Speaking on Jan. 24, Lee highlighted the stark contrast between now and July 2024, when the BOJ’s unexpected rate hike to 0.25% caused significant market disruptions. At that time, the U.S.-Japan rate gap was narrowing, and the yen was stronger, creating conditions for carry trade unwinding. Today, the widening gap and a weaker yen create a more stable environment for these trades to persist.

While the yen carry trade remains robust for now, risks are emerging that could alter the calculus. A stronger yen, driven by improving economic conditions or increased market volatility, could erode the profitability of borrowing in yen. Similarly, if the BOJ accelerates its pace of tightening or signals a more aggressive stance, market sentiment could shift, prompting investors to reassess their positions.

The global financial environment also plays a critical role. For instance, any signs of a slowdown in U.S. economic growth or unexpected moves by the Federal Reserve could impact the dollar-yen exchange rate and the broader appeal of carry trades. Additionally, rising geopolitical tensions or shocks in commodity markets could introduce volatility, further complicating the outlook.

The BOJ’s balancing act

The BOJ’s cautious approach to policy normalisation reflects its understanding of these risks. Governor Kazuo Ueda and his team have emphasized the importance of maintaining market stability, particularly after the disruptions caused by last year’s unexpected rate hike. By signaling their intentions more clearly this time, the BOJ aims to avoid triggering a sudden unwinding of yen carry trades, which could destabilize global markets.

Looking ahead: USD/JPY and market dynamics

For now, the yen carry trade appears resilient, supported by Japan’s relatively low rates and a weak currency. However, the landscape is shifting. As the BOJ moves further along its path of normalization, and as external economic conditions evolve, the sustainability of this trade will come under increasing scrutiny.?

The USD/JPY pair, in particular, has seen volatility in response to the BOJ’s rate move. Following the decision, the yen fluctuated between gains and losses before strengthening by 0.4%, trading at 155.43 per dollar. This movement highlights the market’s sensitivity to the BOJ's actions, including the non-unanimous vote on the rate hike and the upward revision to Japan’s CPI forecast.?

Currency strategist Christopher Wong from OCBC noted that the revised inflation expectations signal the BOJ’s growing confidence in the domestic economy. Recent data revealed that Japan’s core consumer prices rose 3.0% in December, the fastest annual pace in 16 months, signaling sustained inflationary pressures.

However, despite these developments, the substantial interest rate differential between the U.S. and Japan continues to favor dollar-denominated assets, keeping the yen's depreciation intact. While the yen may experience short-term fluctuations, the broader picture suggests that the USD/JPY remains in a position to support yen carry trades.?

At the time of writing, the USD/JPY pair is hovering around the 155.24 price point. The daily chart shows a clear downward bias with prices inching lower towards the 154.80 mark. However, price action inching towards the lower boundary of the bollinger band hints at potential oversold conditions. RSI also looking flat around the mid-line hints at slowing momentum as well.

Sellers could find support at the 154.84 as prices inch down. On the upside, buyers could find a hurdle at the 156.00 and 156.59 resistance levels.?

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Disclaimer:

The information contained within this article is for educational purposes only and is not intended as financial or investment advice. It is considered accurate and correct at the date of publication. Changes in circumstances after the time of publication may impact the accuracy of the information.

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