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Yuan vs. Yen vs. Franc: Shifting Carry Trade Strategies
Charu Chanana
Head of FX Strategy
Key points:
- Carry trades remain popular when there are interest rate gaps between different currencies and volatility is low. JPY and CHF have traditionally been key carry funding currencies.
- However, higher volatility in Japanese yen due to intervention risks and the probability of BOJ normalization as well as haven flows in CHF are sending some cautionary signals on carry trading.
- Amid these challenges, the Chinese yuan (CNH) with controlled depreciation and low rates may become a more attractive option for carry trades.
Carry trading is a popular investment strategy where traders borrow money in a currency with a low interest rate and invest it in a currency with a higher interest rate. The goal is to capture the difference between the interest rates, known as the "carry." This strategy is particularly attractive in times of low volatility, as it relies on stable exchange rates to avoid eroding the gains from interest rate differentials. We discussed more about carry trading in this article.
Historically, the Japanese yen (JPY) and the Swiss franc (CHF) have been the primary funding currencies for carry trades. Both currencies have maintained low interest rates for extended periods, making them cheap to borrow.
However, going into H2, investors may be re-assessing carry strategies with yield differentials likely to narrow, and geopolitical risks expected to spook volatility. These factors challenge the fundamental principles of carry trading—low volatility and interest rate gaps. Consider the below factors:
- Yen Volatility: Recent policy changes by the Bank of Japan (BOJ), including adjustments to its negative rates and yield-curve control policy, have contributed to increased volatility in the yen. Despite these shifts, Japanese yields remain low, causing the yen to weaken further. This instability makes the yen less attractive as a funding currency for carry trades.
- Potential Yen Intervention and BOJ Normalization: The possibility of the BOJ intervening in the currency market to stabilize the yen adds another layer of uncertainty. Additionally, prospects of the BOJ normalizing its monetary policy could lead to increased volatility, further discouraging the use of the yen in carry trades.
- Geopolitical Risks and CHF Safe Haven Flows: The Swiss franc (CHF) is another potential funding currency due to its low interest rates. However, rising geopolitical risks amid the France elections have led to haven flows into the CHF, reducing its attractiveness for carry trades. Going into the second half of the year, geopolitical risks are expected to remain a significant concern for investors, as we approach the US presidential elections in November. This could continue to drive safe-haven flows into the franc, reducing its appeal for carry trades.
These factors could make the Chinese yuan (CNH) a more favorable funding currency compared to the JPY and CHF. The People's Bank of China (PBOC) is deliberately guiding the yuan to a weaker position to support the economy and boost exports. This controlled depreciation, combined with low domestic interest rates, suggest yuan could remain on the path of weakness without any immediate concerns of volatility. Q3 will also likely see more volatility around US elections, and the possibility of a second Trump presidency could be seen as a negative for yuan due to tariffs risks.
However, using yuan as a carry trade funder comes with its risks. The Chinese authorities tightly manage the yuan's value through daily fixings and intervene in markets to prevent excessive depreciation, which can limit potential profits from the trade. Moreover, the yuan's liquidity and accessibility in global markets are not as robust as major currencies like the Japanese yen, affecting execution and hedging strategies. Regulatory changes and geopolitical tensions further complicate the landscape, influencing the yuan's stability and attractiveness for carry trades. Therefore, investors considering the yuan for carry trades should closely monitor regulatory policies, market conditions, and geopolitical developments to mitigate risks effectively.
Disclaimer:
Forex, or FX, involves trading one currency such as the US dollar or Euro for another at an agreed exchange rate. While the forex market is the world’s largest market with round-the-clock trading, it is highly speculative, and you should understand the risks involved.
FX are complex instruments and come with a high risk of losing money rapidly due to leverage. 65% of retail investor accounts lose money when trading FX with this provider. You should consider whether you understand how FX work and whether you can afford to take the high risk of losing your money.
Recent FX articles and podcasts:
- 2 Jul: Quarterly Outlook: Risk-on currencies to surge against havens
- 26 Jun: AUD, CAD: Inflation Rising, Can Central Banks Stay on Pause?
- 21 Jun: JPY: Three-Way Pressure Piling Up
- 20 Jun: CNH: China Authorities Loosening their Grip, But Devaluation Unlikely
- 19 Jun: CHF: Temporary Haven Flows Unlikely to Fuel SNB Rate Cut
- 18 Jun: GBP: UK CPI Details and Elections Will Keep BOE on Hold
- 13 Jun: BOJ Preview: Tapering and Rate Hike Talk Not Enough to Boost JPY
- 10 Jun: EUR: Election jitters and ECB rate cut add to downside pressures
- 30 May: JPY: Intervention fears clash with carry trade attractiveness
- 29 May: AUD: Hot inflation reaffirms rate cuts remain some way off
- 15 May: AUD: Tailwinds to stay despite Budget impact
- 7 May: AUD: RBA fails to meet the hawkish expectations
- 3 May: JPY: Staying on intervention alert
Recent Macro articles and podcasts:
- 1 Jul: Macro Podcast: Politics are taking over macro
- 28 Jun: UK Elections: Markets May Be Too Complacent
- 24 Jun: Macro Podcast: Is it time to diversify your portfolio?
- 12 Jun: France Election Turmoil: European Equities Amidst the Upheaval
- 11 Jun: US CPI and Fed Previews: Delays, but Dovish
- 10 Jun: Macro Podcast: Nonfarm payroll shatters expectations - how will the Fed react?
- 3 Jun: Macro Podcast: It is a rate cut week
- 28 May: Macro Podcast: When speech trump numbers
- 16 May: US CPI: Putting a September Fed Rate Cut Back in Play
- 14 May: US inflation report: How to trade the event
- 8 May: Bank of England preview: Rate cuts in mind, but patience required
- 2 May: Fed Decision: High-for-longer, not higher-for-longer
Weekly FX Chartbooks:
- 1 Jul: Weekly FX Chartbook: Politics Still the Key Theme in Markets
- 24 Jun: Weekly FX Chartbook: US Presidential Debate is the Big Market Unknown
- 10 Jun: Weekly FX Chartbook: US CPI and FOMC dot plot have a low dovish bar
- 3 Jun: Weekly FX Chartbook: ECB and Bank of Canada likely to cut rates
FX 101 Series:
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