The End of a Profitable Carry Trade Strategy and Investors' Search for a Yen Alternative

KEY POINTS

• The Bank of Japan's interest rate hike in July 2024 marked the end of the highly profitable yen carry trade, as the sudden yen appreciation led to significant market losses.

• Investors are now exploring the Swiss franc as a potential alternative funding currency due to its stability, low interest rates, and safe-haven status, though it carries its own risks.

• The collapse of the yen carry trade serves as a reminder of the inherent risks in currency markets, especially during volatile times, and highlights the importance of adapting to unexpected shifts in central bank policies.

👉 Bonus: Below you will find five ChatGPT prompts that you can use to develop your expertise in this area.

In July 2024, Japan’s central bank took a pivotal step that reverberated across global financial markets. After maintaining interest rates at historically low levels for over two decades, the Bank of Japan (BoJ) raised its benchmark rate from 0.1% to 0.25%. This seemingly modest adjustment was a significant break from the ultra-loose monetary policies that had defined Japan’s financial landscape for the past 25 years. More importantly, it marked the collapse of one of the most popular and profitable trading strategies: the yen carry trade.

As a result, many are now on the lookout for a new currency to anchor their carry trade strategies. Among the contenders, one particular currency is standing out: the Swiss franc. Known for its stability and reputation as a safe haven, the Swiss currency has captured the attention of traders and investors looking for alternatives in a rapidly changing financial landscape.

The Yen Carry Trade Unraveled

The yen carry trade had long been a go-to strategy for investors looking to capitalize on Japan’s low-interest-rate environment. Investors borrowed yen at near-zero rates, exchanged them for higher-yielding currencies, and pocketed the interest rate differential. For years, this strategy offered easy profits with minimal risk. But with the BoJ’s rate hike, the foundations of this strategy quickly began to crumble.

As the yen appreciated sharply following the rate increase, investors holding positions in other currencies faced mounting losses. The unwinding of the carry trade became a significant force behind the yen’s rapid rise, causing a sharp market correction in early August 2024. What had once been a stable and reliable trade was suddenly too risky to sustain, and investors scrambled to exit their positions, further exacerbating market volatility.

Why the Yen Carry Trade Worked

To understand the significance of the BoJ’s interest rate decision, it’s crucial to grasp why the yen carry trade worked so well in the first place. Carry trades depend on two key factors: low borrowing costs in the funding currency (in this case, the yen) and stable exchange rate differentials. For decades, Japan’s near-zero interest rates provided the ideal environment for such trades. Borrowing in yen was cheap, and the currency’s stability made it relatively safe to exchange it for higher-yielding currencies such as the U.S. dollar or Australian dollar.

Moreover, Japan’s deflationary pressures and stagnant domestic demand kept the yen weak, which further encouraged investors to borrow yen and invest elsewhere. The stability of the yen combined with the minimal cost of borrowing made it a preferred funding currency for carry trades.

The Shift in Japan’s Monetary Policy

The BoJ’s decision to raise interest rates signaled a shift away from decades of loose monetary policy aimed at combating deflation and spurring economic growth. The Japanese economy, long characterized by low inflation and sluggish growth, had begun to show signs of recovery. With inflation ticking up, albeit modestly, the BoJ found itself under pressure to normalize monetary policy.

For years, global markets had taken Japan’s zero-interest-rate policy for granted. The sudden shift caught many investors off guard. As the yen strengthened, those who had borrowed yen to fund positions in higher-yielding currencies found themselves on the wrong side of the trade. As a result, investors were forced to liquidate their positions, leading to a significant appreciation in the yen and a sharp decline in global stock and bond markets.

A discussion between Frida AI Fridason (Entrepreneur & Advisor, former S(ai)lor) & Tom AI Tomson (Entrepreneur & Investor, former Mount(ai)n Biker) on the topic:

Be aware that this is one of our AI experiments, so Frida and Tom don’t really exist.

A significant number of hedge funds and asset managers had built substantial positions using yen-based financing to profit from higher-yielding assets across the globe, from U.S. Treasuries to emerging market bonds. However, the sudden rise in Japanese rates and the consequent strengthening of the yen meant that the cost of holding such positions increased sharply, eroding profits or even turning gains into losses.

The carry trade, which relies on stable interest rate differentials, becomes unattractive when volatility rises. A 25-basis-point hike might seem trivial in isolation, but in a highly leveraged environment, it can trigger a cascade of market adjustments. Thus, the unwinding of yen-carry trades has prompted investors to seek alternatives with similarly low financing costs but less exposure to unexpected shifts.

The Search for a New Funding Currency

With the yen carry trade no longer viable, investors are now on the hunt for alternative funding currencies. The key criteria remain the same: low-interest rates, currency stability, and ample liquidity.

In the hunt for a replacement currency, investors have begun to zero in on the Swiss franc. Historically, Switzerland has maintained low interest rates to keep its export-driven economy competitive, making it a suitable candidate for funding carry trades. According to a study by J. Safra Sarasin, a prominent Swiss private bank, the franc offers the dual benefit of low borrowing costs and relative stability—two key ingredients for a successful carry trade.

The Swiss National Bank (SNB), under its long-time president Thomas Jordan, had already signaled its intent to maintain a dovish stance. With Thomas’ recent departure, his successor, Martin Schlegel, is expected to continue this approach, potentially cutting rates further by the end of 2024. If so, the Swiss franc would maintain its appeal as a low-cost funding currency for global investors.

However, the attractiveness of the Swiss franc is not without its pitfalls. While it shares some characteristics with the yen—such as being perceived as a “safe haven” during times of global uncertainty—it also carries unique risks. During periods of market turmoil, the franc tends to appreciate significantly as investors flock to its safety. This makes it a double-edged sword for carry traders, who could face mounting losses if the franc strengthens unexpectedly.

Why the Swiss Franc?

Several factors are essential for a carry trade to work: wide interest rate differential, low volatility, stable interest rates, predictable monetary policies of countries involved, and a positive broad risk appetite. If any of these factors change rapidly, the results may be unpredictable.

These factors make the Swiss franc a compelling option in the post-yen era. First, it benefits from a stable economic environment and a strong financial system. The country’s low inflation and prudent fiscal policies offer reassurance to investors who value predictability. Second, the franc’s relatively low yield compared to other major currencies means that it is cheap to borrow, allowing traders to leverage positions in higher-yielding assets elsewhere.

One additional factor is the reputation of the SNB itself. While the Bank of Japan’s move was unexpected, the SNB has been more transparent in signaling its policy intentions, reducing the likelihood of sudden surprises. Investors view the SNB’s communication strategy as a stabilizing influence, which is crucial in an environment where even small policy changes can lead to significant market disruptions.

Risks and Limitations of the Swiss Franc Strategy

Despite its allure, the Swiss franc is not a perfect substitute. Its status as a safe-haven currency means that it is prone to sudden upward pressure in times of global uncertainty. During such periods, investors tend to flock to the franc, driving up its value and creating a headache for those who have used it as a funding currency. In other words, what makes the franc appealing in calm times can become a major drawback when markets turn volatile.

This phenomenon was most recently observed during the COVID-19 pandemic and the Russian invasion of Ukraine, where the franc saw sharp upward spikes as investors sought refuge. For carry traders, who typically borrow in low-yielding currencies and sell them to invest in riskier, higher-yielding assets, this can lead to significant mismatches if the borrowed currency appreciates too much.

5 PROMPTS THAT ATHLETES CAN USE TO DEVELOP AND BUILD EXPERTISE

• Explain how central bank policies, like Japan’s interest rate hike, can impact global investment strategies and suggest how I can adapt my business investments to similar economic shifts.

• What are carry trades, and how can I apply the principles of currency trading to diversify my investment portfolio while managing risks in a volatile financial market?

• Analyze the role of safe-haven currencies like the Swiss franc in investment strategies, and guide me on how I can leverage stable currencies to protect my business assets during global financial uncertainty.

• How can I learn from the collapse of the yen carry trade to avoid over-reliance on specific investment strategies, and what steps can I take to build a more resilient business portfolio?

• Provide a detailed comparison of low-interest-rate environments across different countries, and advise on how I can use this knowledge to secure favorable financing or make better investment decisions in my business.

👉 Check ChampionsChat GPT for your prompts.

The Risk of Carry Trades: Navigating a New Landscape

The end of the yen carry trade has left investors in search of new opportunities, but the landscape has shifted. Currencies that were once considered stable, low-risk options for funding trades are now fraught with uncertainty. As the global financial environment continues to evolve, investors must weigh the risks of each currency carefully.

The collapse of the yen carry trade is a sobering reminder of the inherent risks in currency markets. Carry trades are inherently risky. They rely on the stability of exchange rate differentials, and sudden market shifts can quickly turn profits into losses. The yen carry trade’s collapse is a stark reminder of these risks. Political uncertainty, market shocks, and unexpected central bank moves can all undermine the assumptions that carry trades are based on.

The 2024 yen crisis also highlighted the dangers of assuming that central banks will stick to their policies indefinitely. For years, the BoJ’s commitment to low-interest rates was seen as unshakeable. But as Japan’s economic conditions changed, so did the central bank’s stance. This underscores the need for investors to remain vigilant and adaptable.

As central banks around the world adjust their policies in response to shifting economic conditions, investors will need to remain nimble, ready to adapt their strategies to an increasingly volatile world. While the hunt for the next profitable carry trade continues, the lessons of 2024 will not soon be forgotten.

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I really appreciate you reading my note today.

Have a great weekend,

Irg

Irg’s work is provided for informational purposes only and should not be construed as legal, business, investment, or tax advice. You should always do your own research and consult advisors on these subjects. This work may feature assets and entities in which the author has invested.

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