The FX trade that ticked all the boxes
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All four ways people invest in the currency markets contributed to the historic weakness of the yen — and then its violent bounce back over the past month.
Why it matters: Yen traders made front-page news this week as a sharp unwind of their positions caused stock markets in Japan and globally to sink.
State of play: Currency investing broadly falls into four separate quadrants. The investors can be institutional or retail, and the type of investing can be carry or momentum.
- With the yen, all four quadrants were in play — institutional and retail investors were engaging in a trade that was both carry and momentum.
The big picture: In the U.S., investing is generally thought of, first and foremost, as investing in the stock market. That's not the case in the rest of the world.
- In Japan, households have historically saved their money in bonds rather than stocks. From there it's only a short hop to the FX markets.
How it works: Because Japan has had ultra-low interest rates for decades, individual Japanese investors looking for non-negligible yields started looking at dual-currency notes, where coupon payments or the principal amount would be repaid in a foreign currency. That could be the Australian or U.S. dollar, or, for even more risk and even higher yields, it could be something like the South African rand.
- Such notes are a form of carry trade — the investors' yen, which would normally earn a negligible yield, gets sold, and a higher-yielding currency is bought. The investors then enjoy the higher yield and hope the yen won't appreciate so much that their higher coupons get erased in FX losses.
Between the lines: Institutional investors, like U.S. hedge funds, also play the carry trade. In their case, however, they don't have Japanese yen to begin with, so they have to borrow the yen in Japan before selling it in the FX market and buying a higher-yielding currency.
- Those institutional investors normally invest in very short-term money-market instruments rather than in longer-term bonds, so they can remain liquid and unwind the trade at will.
Catch up quick: Once individual investors got used to the idea of investing in foreign currencies, they soon started playing in the FX markets directly, rather than by buying bonds.
- The classic play in FX investing is the same for both individuals and institutions: Buy a currency that is appreciating, or sell one that is depreciating. That's a strategy known as "momentum," and it generally works.
By the numbers: Both the carry trade and the momentum trade tend to be surprisingly successful, generating equity-like returns with lower volatility.
- From early 2022 through mid-2024, they both worked wonders in Japan. The Japanese yen had super-low yields, making it the perfect funding currency for the carry trade; it was also depreciating rapidly, making it a perfect momentum trade.
- Either way, the trade involved shorting the yen and going long some other currency, normally the U.S. dollar.
Reality check: Stein's Law — that if something can't go on forever, it won't — always applies. The yen had to stop depreciating eventually, and the nature of fx markets is that such moves rarely happen slowly.
- Instead, the carry trades and momentum trades all get unwound at the same time, which means a huge wave of yen buying, and a sharp appreciation. That's what's happened over the past month, and might yet continue for a while.
The bottom line: Currency trades can be very profitable, but they're never buy-and-hold investments. Indeed, they can sometimes interfere with stock market strategies in spectacular fashion.
