Will the carry trade continue with Bank of Japan’s monetary stimulus expansion?
Carry trade, which simply involves borrowing one currency (in order to sell it with a purpose of buying back and returning to the lender) to fund or buy another currency, has been a long preferred way for investors. While in the past, interest rate differentials would often dictate the carry trade flows, with the onset of global Central Bank’s quantitative easing policy, carry trades have become the norm with the Japanese Yen being the favorite among investors and traders alike.
With the Japanese interest rates at historical lows and its massive quantitative easing policy in place in an effort to stave off deflation while trying to steer towards the Central Bank’s target of 2%, the Yen has often found to be the ‘go to’ currency when it comes to carry trade strategy.
From a forex trading perspective, the USDJPY carry trade might not offer much, but from an investor perspective, borrowing the Yen to fund the US currency to invest in the equities has been something significant for the US equity markets, one of the reasons for the strong bullish rally in the stock markets which has been supported despite a few hiccups in between.
As the US Federal Reserve ended its QE3 program with the final taper of $15bn in October, carry trade enthusiasts got a shot in the arm just a few days later as the Bank of Japan announced its surprise stimulus expansion that literally rocked the markets, that was still trying to digest the FOMC news.
By further expanding its monetary policy to 80 trillion Yen (or about $700 billion) a year, Bank of Japan’s Governor Haruhiko Kuroda pledged that the easy monetary policy would continue until the BoJ starts to see some signs of revival in the Japanese inflation. Needless to say, the markets reacted violently with the Yen weakening substantially while the Nikkei 22 Index breaking an all time high record of 16500 during the intra-day trading.
With attention in the US now shifting to the interest rate hike timetable the current conditions for carry trade couldn’t come at a more opportune time, although it would have been a sweet spot had the BoJ’s decision to raise its stimulus would come at a much closer period ahead of the US interest rate hike.
As and when the US Federal Reserve will start confirming the interest rate hike timetable, we could expect to see the US equity markets also start to soar as investors focused on carry trade would not only gain from the low funding costs but also look to eye some extra benefits of the interest rate differential between the Bank of Japan and the Federal Reserve. While there have been many critics who continue to take a dovish stand on the outlook of the US economy, dubbing the Federal Reserve’s monetary policy as ‘QE infinity’, the BoJ’s QQE could likely hold the key and help the US equity markets fare the choppy waters as and when the interest rates in the US start to climb. Another factor to bear in mind would be the implications of a possible QE from the ECB which has been widely talked about. Regardless of the speculation or the rumors, it seems very likely that the carry trade is here to stay.