Due to concerns about a U.S. economic recession and the impact of the Bank of Japan's interest rate hike, yen volatility has surged dramatically over the past week, severely affecting foreign exchange trading. Yen carry trades, where investors borrow cheaply in Japan and buy higher-yielding assets elsewhere, have long been popular because volatility has been low and traders have bet that Japanese rates would remain at their lowest levels.
However, over the past month, the dollar has depreciated by 11% against the yen, leading to losses in many such trades.
Subsequently, investors have rushed to close out their short yen positions, impacting both emerging and developed markets that have served as destinations for these higher-return strategies.
The Mexican peso is one of the biggest victims of these trades being closed, continuing to decline earlier this week, dropping 6.8% over the past month, the largest drop among major world currencies tracked by Bloomberg.
Sandilia indicated that carry trades are unlikely to return to pre-yen appreciation levels in the short term, as the technical damage to investment portfolios from sharp short-term volatility is "not easily mitigated."
"A good scenario would be for the market to stabilize around current levels, with at most a slight recovery," he said. "But in many instances, markets tend to continue fluctuating, just at a slower pace than before."
Japanese Senior Economist Taro Kimura said, "Yen carry trades appear to be unwinding at the fastest rate since the yen surged following the 2007 subprime crisis. Since March, we’ve been cautious about the risk of a sharp reversal in the yen's fortunes, and now that risk is becoming a reality."
He noted, "Our model shows that concerns over a U.S. economic slowdown are the main driver, rather than the recent rate hike by the Bank of Japan. The future direction of the yen will likely depend largely on the evolution of the U.S. economy and the Fed's policy responses."
According to data provided by the U.S. Commodity Futures Trading Commission (CFTC) last week, yen short-covering had already begun before Monday's sell-off, even though it is not yet fully completed. The data showed that leverage funds had been increasing their bets on further yen depreciation ahead of the Bank of Japan's rate hike on July 31.
The summary of opinions from the Bank of Japan's July monetary policy meeting noted, "Several members believe that developments in economic activity and prices are consistent with the Bank of Japan's outlook. Some see room to raise the 'very low' policy rate, citing that real negative rates are at their lowest point in 25 years."
The summary also mentioned, "Differences in opinion revolve around the timing, with some wanting more data, while others are ready to act immediately. Bank of Japan members expect that a small rate increase would not have a tightening effect, and they urge timely rate hikes to avoid the necessity of rapid increases. Members view at least a 1% neutral rate as a mid-term target. The plan to reduce JGB purchases was seen as promoting market function rather than tightening. The Bank of Japan's reduction in purchase volumes needs careful monitoring of the JGB market. The debate over the sustainability of the inflation/wage growth cycle continues."
