Carry Trade: Not Dead

Yen-funded carry trades are not finished, despite reports to the contrary. To paraphrase Mark Twain, reports of its death have been greatly exaggerated. All three commodity currencies, the Australian dollar, the New Zealand dollar and the Canadian dollar, gained against the yen last night. High oil prices and bad Japanese economic data spurred the poor results. Even the US dollar was able to pick up value against the yen yesterday, despite the inaction by the Fed. The yen gains in the forex market earlier in the week now look like a bout of international risk aversion. But with the momentary blip over, yen shorting should resume with a vengeance.

There are many reasons for the current yen weakness. The data released earlier this week was fairly yen-positive. Retail Sales and some investor indices proved encouraging for yen bulls. But the name problem with the Japanese currency has always been the country’s battle with deflationary pressures. The interest rate has been so low for so long, and economic policy makers in Japan are powerless to raise interest rates until growth picks up and inflation returns to the economy.

But the last couple of reports coming out of Japan do not leave much hope for the country. On the growth front, Industrial Production fell 0.4% when most forex analysts were predicting a 0.9% gain. And even more damaging for those predicting an interest rate hike, the CPI report this morning showed a drop in prices of 0.1%. Before final decisions on the yen are made, there is still some data on tap, including overall household spending, the jobless rate and manufacturing PMI. But if deflation persists, the Bank of Japan cannot raise rates in July or August, further dooming the currency.

The yen is easily the most undervalued currency in the forex market, at least among the most highly traded currencies. It has lost 4.3% against the US dollar this quarter. That puts it on track for its biggest quarterly loss against the dollar since 2001. Most of that is due to the popularity of yen-funded carry trades, fueled by the low interest rates in Japan. The majority of currency analysts expect those carry trades to continue to outperform. With the growth and inflation outlook in Japan looking as dire as it does right now, it would be foolish to predict the end of the carry trade wave and the end of the yen slide.