JPY: Unwinding of carry trades?

The dramatic movement of the Japanese Yen (JPY) in recent times is being sold everywhere as the ‘unwinding of carry trades’. This suggests that speculative investors have so far taken short positions in the JPY, which they financed with the low JPY interest rates, in order to invest the funds thus obtained in higher-yielding currencies. These speculative investors were thus aiming to reap a secure interest rate advantage, according to this story, Commerzbank’s Head of FX and Commodity Research Ulrich Leuchtmann notes.

The unwinding of carry trade make little sense

“As a metaphor, this story is not bad at all. It only becomes misleading if you take it too literally and calculate, for example, what percentage of the carry trade has already been unwound. Why? Because a carry trade described in this way makes little sense. Let's take the example of USD/JPY.”

“In mid-July, the low point of the implied 1-year volatility was around 9%, the USD interest rate around 5.2% and the JPY interest rate around 0.25%. This means that while it was possible to earn almost 5% p.a. on a USD/JPY carry trade, the market expected the spot rate to fluctuate by an average of 9% over the course of the next 12 months.”

“The fact that exchange rate movements appear excessive to the layperson, that it may seem implausible, for example, that a 25 basis point increase in JPY interest rates justifies a USD/JPY slide by more than 10 big figures, is of course due to a dynamic that is quite well understood by economists. As early as the 1970s, Rudi Dornbusch explained with his overshooting model why this must be the case. ‘Unwinding of carry trades’ does not appear anywhere in this explanation.”

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