One of the currency world’s most lucrative trading strategies suffered a setback on Friday after the Bank of Japan surprised investors by edging closer to ending its extraordinarily loose monetary policy.
(Bloomberg) — One of the currency world’s most lucrative trading strategies suffered a setback on Friday after the Bank of Japan surprised investors by edging closer to ending its extraordinarily loose monetary policy.
The carry trade, where investors borrow money in currencies with low rates and invest in higher-yielding assets, is showing signs of faltering after the BOJ tweaked its policy in a way that essentially lifts the cap on 10-yields to 1% from 0.5%. The MSCI index that tracks emerging markets FX — some of the world’s highest-yielding — fell as much as 0.4%.
While far from spelling the strategy’s demise, the change in Japan’s monetary policy is undoubtedly a headwind, according to Simon Harvey, the London-based head of FX analysis at Monex Europe Ltd. Japan boasts the world’s lowest interest rates and yen-funded carry trade strategies have outperformed those borrowed in dollars in all developing markets this year, based on data compiled by Bloomberg.
“It goes without saying that the rise in the lowest risk-free rate globally will definitely inflict further pressure on EM carry trades,” Harvey said.
Broader signs of caution over carry trades have already become more evident. BNY Mellon’s iFlow indicator, which captures portfolio flows, showed that the strategy tilted from being extremely overvalued to be within a more normal range this week.
“BOJ actions overnight are a warning shot,” said Bob Savage, head of markets strategy and insights at BNY Mellon. “JPY volatility is going up and it’s clearly under-held and undervalued.”
Still, given that Japanese front-end rates remain pinned around 0%, the yen will still screen as a very attractive funder for some time yet. The MSCI emerging-market currency index pared its loss during Friday and was still poised for a 0.3% gain for the week by 3:47 p.m. in London.
“The carry trade still works in terms of the yield differential,” said Kit Juckes, global head of FX strategy at Societe Generale. “The carry traders know that they’re earning carry today and they’ll keep on it, but they’re getting closer to the point where that game ends.”
Carry has been a major contributer to the relative total return performance of emerging markets this year, according to Teresa Alves at Goldman Sachs Group Inc. The Mexican peso, South Africa’s rand, the Polish zloty and the Turkish lira are among the most popular emerging-market currency trades with Japanese retail investors, who dominate Tokyo’s foreign-exchange market.
Read more: Japan Mom-and-Pop Traders Lift Emerging-Market Currency Bets
Twenty four of 26 domestic benchmark bonds monitored by Bloomberg were flat or lower Friday. Yields on South Korea’s bonds due 2033 climbed 10 basis points to 3.76% the highest since March. Yields on South Africa’s rand-debt due 2035 rose as much as 11 basis points, the most in two weeks.
The carry trade could come under greater pressure once the BOJ starts to hike, particularly if other central banks that began raising borrowing costs far sooner are already cutting rates by then.
“Bottom line, BOJ overnight is not a broad game changer for carry trades,” said Stephen Gallo, global FX strategist at Bank of Montreal. “When the BOJ actually tightens policy, if it happens alongside continued global QT and other central banks remaining tight — then it could be a massive deal.”
Even then, the damage may not be as bad as feared.
“I don’t see a huge hit to carry trades even as the BOJ allows rates to rise a bit,” said Steven Barrow, head of G-10 strategy at Standard Bank. “I think that investors will still remain pretty bullish for the other side of the trade, and again, even if yields in the higher-yielding country are coming down.”
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