A Bloomberg report suggests the yen carry trade may be making a comeback after Japan’s recent election. This strategy means borrowing yen at low interest rates to invest in assets that offer higher returns abroad. With Prime Minister Shigeru Ishiba losing his majority in the upper house, the government might increase spending to win support from the opposition. This uncertainty in politics could lead the Bank of Japan to slow down its interest rate hikes, which might weaken the yen and make carry trades more attractive.

Yen’s Performance After the Election

Since the election, the yen has risen in value, which might put early carry trade investors at risk of foreign exchange losses. The changing political and economic climate could also affect the yen’s performance in the future. We view the yen carry trade as an effective strategy, mainly because of the large interest rate difference between Japan’s near-zero rates and the U.S. rates above 5%. Political pressure for economic stimulus may keep the central bank cautious about raising rates. This environment encourages borrowing in yen to invest elsewhere. However, this trade is crowded and carries risks, especially since the yen recently fell past 160 to the dollar, hitting a 34-year low. It’s important to note that Japanese authorities likely intervened with about $60 billion in late April and early May to stop this decline. This intervention sets a significant risk for traders betting on a continued decrease in the yen’s value.

Volatility and Strategic Considerations

Given the current situation, we suggest that derivative traders focus on managing volatility rather than simply betting on the market’s direction. The implied volatility of yen options remains high, indicating expectations of sharp and unpredictable market movements. Strategies that benefit from sudden spikes in volatility or protect against unexpected reversals seem wiser than merely shorting the currency. We must learn from past events, especially the 2008 financial crisis. During that time, the carry trade unwound quickly. As global risk sentiment fell, investors moved funds back to Japan, causing a more than 20% rise in the yen against the dollar in just a few months. A similar global event could lead to another rapid and painful reversal for those who are not ready. In the upcoming weeks, a smart approach might be to buy inexpensive out-of-the-money puts on currency pairs like USD/JPY. These options serve as low-cost insurance against an unexpected increase in yen strength, which could result from doubts about policies or further government intervention. This way, investors can take advantage of the carry trade’s yields while protecting against the major risks discussed. Create your live VT Markets account and start trading now.

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