For the past five years the Japanese yen has defied the laws of physics, rising relentlessly against many of the world’s major currencies. Now however, the primary factor that contributed to a strong yen, i.e. the unwinding of the yen carry trade, is coming to an end. Add to that Japan’s highly precarious and rapidly deteriorating fiscal position and you have the recipe for a major trend reversal and a substantially lower Japanese currency.
This article examines the impact of the unwinding of the yen carry trade, as well as how to profit from the coming decline of the yen.
What is a carry trade?
In order to understand the impact of the unwinding of the yen carry trade, it’s first necessary to understand what a carry trade is.
A carry trade is a strategy in which an investor borrows money in a country with a low interest rate and uses the funds to invest in assets in a country with a higher interest rate. The investor then attempts to capture the difference between the two rates, which can often be substantial, depending on the amount of leverage used.
This investment strategy was used extensively between 1998 and 2007 to borrow money in Japan and invest in countries with much higher yields, such as the BRIC counties and the United States.
In an attempt to spur economic growth, Japan lowered its interest rates to close to zero making it profitable to borrow Japanese yen and invest in resource rich emerging markets, and activities such as subprime lending in the US.
The trade proved so lucrative that by early 2007, it was estimated that as much as US$1 trillion may have been staked on the yen carry trade.
The unwinding of the yen carry trade
The arrival of the global financial crisis in the summer of 2007 triggered the beginning of the end of the yen carry trade as risky leveraged bets funded with cheap money started to be unwound. As a result hundreds of millions of dollars have had to be converted into Japanese yen in order to repay the low-interest loans.
This unwinding process created tremendous demand for yen which caused it to rise considerably against other world currencies.
Since 18 June 2007 the US dollar has fallen 36% against the yen, while other higher yielding currencies such as the New Zealand dollar and Australian dollar have fallen much more.
A monthly chart of the USD/JPY showing the decline of the US dollar relative to the Japanese yen
Chart courtesy of fxstreet.com
The end of the unwinding process
After five years, it now looks as though the unwinding process has come to an end and with it the support for the Japanese currency.
As this chart shows, the yen has now begun to weaken relative to the US dollar, and it’s a similar story with other world currencies.
A daily chart of the USD/JPY showing a break out from the long down trend
Chart courtesy of fxstreet.com
Japan’s precarious and rapidly deteriorating fiscal position
The unwinding of the yen carry trade is not the only reason for the Japanese currency’s bleak outlook. Japan also has a precarious and rapidly deteriorating fiscal position. I have discussed before that on aggregate Japan is now the most indebted nation in the world, however their situation is forecast to get considerably worse over the next four years.
Source: IMF. Note: government net debt as a percentage of GDP, now vs. 2016
It’s not merely the size of Japan’s debt that poses a threat, it’s also the average maturity.
Japan has over 900 trillion yen ($11.35 trillion) in outstanding sovereign debt, the majority of which matures in the next 2.5 years. By the end of 2015 Japan will have to roll over half their entire outstanding debt.
The nation is also suffering from demographic stresses. As Japan’s Baby Boomers begin to retire they are starting to draw down on their pension funds, rather than pay into them. As a result the Japan’s Government Pension Investment Fund (GPIF) – the largest pension fund in the world – has been forced to begin selling Japanese government bonds (JGBs). This is a major concern issue since the GPIF owns almost 12% of all outstanding JGB and it not looks as though it will be a net seller of Japanese debt.
The precarious nature of Japan’s fiscal position makes it all the more likely that they will soon run in to funding difficulties. At which point they will have to choose between austerity (and economic contraction), and money printing, both of which are negative for the value of the yen.
How to play the coming decline of the yen
There are several different ways to capitalise on a weaker yen, but perhaps the best option for longer-term investors is to consider buying a selection of Japanese exporters that stand to benefit from a lower yen. Some names to consider include car companies such as Toyota, Mitsubishi and Nissan, as well as electronics manufactures like Canon, Panasonic, Sony and Nintendo.
These companies are likely to see greater demand for their products thanks to the greater relative purchasing power of foreign buyers. In fact, some of these companies are already beginning to raise their profit forecasts.
Another option for those that want direct exposure to the movement of the yen relative to the US dollar, would be to consider going long the USD/JPY December contract via a spread bet. It must be noted, however, that this is a much riskier proposition, and therefore is really only for those with considerable trading expertise.