Carry Trade Unwind Boosts Japanese Yen Dominance in Forex Market

Dollar Under Pressure Due to Interest Rates and Yen

• Rising speculations about Japanese interest rate hikes
• Increasing inflationary pressures on the Bank of Japan
• Full pricing of US interest rate cut probabilities

Due to the rapid unwinding of carry trade positions ahead of the Bank of Japan meeting, the Japanese yen has surged in the foreign exchange market, showing a stellar performance against most major and minor currencies.

Speculations have increased about a second interest rate hike in Japan this year, coupled with a reduction in bond purchases, amidst growing inflationary pressures on Japanese monetary policymakers.

As the Bank of Japan accelerates its steps toward normalizing monetary policy, most global central banks are moving towards easing their monetary policies.

This undoubtedly means a narrowing of the interest rate gap between Japan and advanced economies, which had been significantly weighing on the yen’s exchange rate and strongly supporting the increase in carry trade positions.

With the probabilities of the US Federal Reserve cutting interest rates twice this year fully priced in, the USD/JPY pair has led the unwinding of carry trade positions.

On the list of winning currencies, the Australian dollar has lagged due to risk aversion in global markets, coupled with concerns about the Chinese economy, Australia’s largest trading partner.

Before delving into the reasons supporting the Japanese yen and heavily pressuring the Australian dollar, let’s first look at the performance of the eight major currencies in the foreign exchange market over the past week.

The Japanese yen rose by 30 points on the “FX News Today” weekly currency strength index, followed by the Swiss franc in second place with 10 points, and the US dollar in third place with 3 points. The Australian dollar ranked last with a negative 20 points.

Japanese Yen

Looking at the detailed performance of the Japanese yen last week against the seven major currencies, it surged against the Australian dollar, gaining 4.55%, and reached its highest level in three months at 99.21 yen on Thursday, July 25.

It climbed by 4.45% against the New Zealand dollar, reaching its highest level in five months at 89.80 yen on Thursday. It increased by 3.2% against the Canadian dollar, reaching a four-month high of 109.89 yen on Thursday.

It added 2.8% against the British pound, reaching a two-month high of 195.85 yen on Thursday. It rose by 2.65% against the euro, reaching a two-month high of 164.82 yen on Thursday.

It gained 2.4% against the US dollar, reaching a two-and-a-half-month high of 151.94 yen on Thursday. It increased by 1.8% against the Swiss franc, reaching a two-month high of 172.33 yen on Thursday, July 25.

What is Carry Trade?

Carry trade is one of the best and most important strategies used by many experts and traders in the trading world. It is a way to build long-term trading positions to take advantage of interest rate differentials between currencies in the forex market.

Carry trade transactions in the forex market involve selling a low-yielding currency and buying a high-yielding currency, financing the trading position daily, weekly, or any period chosen by the trader, allowing them to benefit from the interest rate differential.

The low-yielding currency is referred to as the “funding currency,” while the high-yielding currency is the “yield currency.” In the USD/JPY pair, the yield currency is the US dollar, and the funding currency is the Japanese yen.

Traders borrow in the low-yielding yen through forward points daily, weekly, or any period they choose, and lend the high-yielding US dollar through forward points.

If we assume that the yields on the low-yielding currency will continue to decline or the yields on the high-yielding currency will continue to rise, financing this trade daily is an easy way to achieve profits.

Unwinding Carry Trade Positions

Currently, there is an accelerated unwinding of long-term carry trade positions on the Japanese yen due to strong speculations about the upcoming monetary policy meeting of the Bank of Japan scheduled for late July.

Sources told Reuters that the Bank of Japan is likely to discuss whether to raise interest rates and unveil a plan to halve bond purchases in the coming years, indicating its intention to steadily retreat from its massive monetary stimulus.

In contrast, weak economic data in the United States has raised the probabilities of the Federal Reserve cutting US interest rates by 25 basis points in September from 94% to 100% and in November from 98% to 100%.

Thus, the Bank of Japan is set to take new steps towards normalizing monetary policy for the world’s third-largest economy, while the Federal Reserve is…