What about the Yen?
Carry Traders are getting greedy as they are pushing the Yen way below a fundamentally justified value. The odds are rising that this will backfire for them soon.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
TLDR Summary
The depreciation of the Yen against the Dollar is quite spectacular. It’s down 35% since early 2021 and about 50% since 2012. From a fundamental perspective, the Dollar is now overvalued against the Yen like never before. There may be good reasons for a strong Dollar as the US economy continues to be immensely successful. But it could easily lose 20% and still retain a healthy premium against the Yen.
The recent acceleration of the Yen’s decline is somewhat surprising because the Japanese economy is actually doing quite well, at least relatively speaking compared to their stagnant history. Their trade balance is improving and the worst demographic momentum is behind them.
With inflation (mostly) under control and a decent economy, there is really only one factor left that can explain the latest FX dynamics: the Dollar-Yen carry trade. Borrowing in Yen and investing in Dollars has been hugely successful lately because of the large interest rate differential and the strong performance of the Dollar. The profitability of this trade has exploded since 2021. It’s up more than 50% since then on an unlevered basis.
The total size of this trade is uncertain, but there are signs that is is a major force in FX markets. Movements in US rate expectations are important determinants for the JPY/USD exchange rate. Pricing out most of 2024 rate cuts has reaccelerated the depreciation of the Yen because it encouraged carry traders load up. Derivatives positioning is also supportive of the hypothesis that this may be a crowded trade ripe to pop. US derivatives short positioning is in the 99% percentile on record.
I don’t know when this trade will unravel. It’s in Jerome Powell’s hands alone. I also don’t know how much of an impact it will have in markets broadly when it does. But I do know that there will be at least some mean reversion eventually. I have therefore shifted some of my cash savings into Yen.
What drives FX rates?
The price of a currency is determined by its supply and demand for it. Its supply is set by the issuing central bank and its commercial bank agents that multiply the currency units in circulation by facilitating borrowing therein.
Based on the existing supply, demand for the currency can then come from two sources:
Trade balance: Strong international demand for domestic production increases demand for the currency.
Capital balance: Strong international demand for domestic investment opportunities increases demand for the currency.