The Unwinding of Carry Trade: A Misleading Story
The recent movement of the Japanese Yen (JPY) has been attributed to the ‘unwinding of carry trades’ by many. This narrative suggests that speculative investors have been taking short positions in the JPY, funded by low JPY interest rates, to invest in higher-yielding currencies. According to Commerzbank’s Head of FX and Commodity Research, Ulrich Leuchtmann, these investors aimed to gain a secure interest rate advantage.
But is this story accurate? Not quite. While the metaphor is not bad, taking it too literally can lead to misleading conclusions. Let’s consider the example of USD/JPY.
In mid-July, the implied 1-year volatility was around 9%, with USD interest rates at 5.2% and JPY interest rates at 0.25%. This means that a USD/JPY carry trade could potentially earn almost 5% annually, but the market expected the spot rate to fluctuate by an average of 9% over the next 12 months.
The seemingly excessive exchange rate movements, such as a 25 basis point increase in JPY interest rates leading to a significant USD/JPY slide, are actually well understood by economists. The dynamic nature of these movements has been explained by economists like Rudi Dornbusch in the 1970s through models like the overshooting model.
In conclusion, the concept of the ‘unwinding of carry trades’ may not accurately capture the complexities of currency movements. It is important to look beyond the surface narrative and understand the underlying economic dynamics at play. This understanding can help investors make more informed decisions and navigate the financial markets more effectively.
Analysis: The article discusses the popular narrative of the ‘unwinding of carry trades’ to explain the movement of the Japanese Yen. It challenges this narrative, highlighting the complexities of currency movements and emphasizing the need for a deeper understanding of economic dynamics. By unpacking this narrative, readers can gain insights into the intricacies of the financial markets and make better-informed investment decisions.