Yen arbitrage trading—a highly popular investment strategy this year—is making a comeback.
According to Bloomberg's analysis of data from the Japan Financial Futures Association, the Tokyo Financial Exchange, and the U.S. Commodity Futures Trading Commission, retail investors in Japan and foreign leveraged funds and asset management companies have reportedly increased their bearish bets on the yen from $9.74 billion in October to $13.5 billion in November.
Speculators are starting to rebuild their short positions on the yen.
Due to the large interest rate gap, increased borrowing by the U.S. government, and relatively low volatility in the money market, it is expected that these bets will increase next year. Under these conditions, borrowing in Japan and then investing the funds in the global high-yield markets becomes more attractive.
Alvin Tan, head of Asian foreign exchange strategy at Royal Bank of Canada in Singapore, said: "The absolute interest rate differential of other currencies relative to the yen is very large, which means it will always be seen as a funding currency. The main reason it is not used as a funding currency for arbitrage trading is volatility."
Strategists from Mizuho Securities and Saxo Markets suggest that arbitrage trading may return to levels seen earlier this year, after investors suddenly exited this trade following the Bank of Japan's interest rate hike in July. It's important to note that Trump's return to power could cause turmoil in the currency markets.
The widespread adoption of this investment strategy could impact global markets. The unwinding of yen arbitrage trading this summer wiped out about $6.4 trillion from global stock markets in just three weeks, and the Nikkei 225 index experienced its largest drop since 1987. Last week's sudden surge in the yen highlighted the ongoing risks faced by investors who re-entered arbitrage trades.
Interest rates are the driving force behind such trades. The average yield on ten high-yield currencies from the G10 and emerging markets exceeds 6%. In contrast, the Bank of Japan's benchmark rate is only 0.25%, and the yield on the yen is nearly zero.
The yield on the yen lags far behind other currencies.
Despite the Bank of Japan gradually raising interest rates, the yield differentials with major economies like the U.S. remain significant. The Fed cut rates again by 25 basis points in November, bringing them down to a range of 4.5%-4.75%. Felix Ryan, a foreign exchange analyst at Australia and New Zealand Banking Group in Sydney, believes that even if Japan raises rates to around 1%, the logic for arbitrage trading remains valid.
This strategy has been very profitable. Since the end of 2021, yen arbitrage trading targeting ten major currencies and emerging market currencies has achieved a return of 45%, whereas the S&P 500 index return, factoring in dividend reinvestment, was just 32%.
This has attracted more and more arbitrage investors, with short positions on the yen reaching $21.6 billion at the end of July (just before massive unwinding).
Charu Chanana, chief investment strategist at Saxo Markets, stated: "The Bank of Japan's rate hikes are unlikely to be sufficient to narrow the yield gap between Japan and the U.S. Given that U.S. debt and fiscal conditions are clearly a top concern for the incoming Trump administration, there may still be space for yen arbitrage trading to remain attractive."
In recent months, the dollar and U.S. Treasury yields have surged due to speculation that Trump's tariffs and tax cuts will boost the economy and inflation, potentially slowing the Fed's pace of rate cuts.
Market worries have eased somewhat since Trump nominated Scott Bessent as Treasury Secretary. However, Shoki Omori, chief strategist of Mizuho Securities Japan, believes that Trump will ultimately decide U.S. fiscal policy.
"Ultimately, it all comes down to Trump," Omori said, believing that arbitrage trading could make a comeback as early as January next year. "People forget the political risks associated with Bessent. If Bessent wants to stay on, I don't think he would be so rigid on budget issues."
The trade war threat under Trump could also weigh on global assets, especially after last week's vow to impose additional tariffs on China, Canada, and Mexico.
Although the Mexican peso has long been the preferred currency for yen arbitrage trading due to its double-digit interest rates, Trump's comments could create enough volatility to make this trade less attractive.
This is important because arbitrage trades funded in yen benefit from lower volatility in the currency markets. A gauge of currency volatility from JPMorgan has fallen back from pandemic-era highs, despite rising uncertainty from Trump's new administration and escalating conflict in Ukraine.
Volatility in the global foreign exchange market remains low.
However, some believe that the narrowing of interest rate differentials will keep the momentum for arbitrage trading subdued next year, especially after Bank of Japan Governor Ueda opened the door for a rate hike in December. Japanese officials are also cautious about the yen, with the finance minister stating last month that there has been a sharp one-way movement in the yen since late September.
Due to structural issues such as significant capital outflows, the yen has performed the worst among G10 currencies this year. Although the yen's exchange rate against the dollar had risen to the 140 level a few months ago amid the unwinding of interest rate differential trades, it has now returned to around 150.
Jane Foley, head of foreign exchange strategy at Rabobank, said: "The Japanese Ministry of Finance has re-engaged with speculators through verbal intervention, and comments from Bank of Japan Governor Ueda have kept market concerns about a rate hike in December alive. While arbitrage trading has gained further support, 'this should ensure that arbitrage trading lacks significant confidence and momentum in the spring of next year.'
Before the December meetings of the Bank of Japan and the Fed, investors may gain further insights into arbitrage trading. Ueda's dovish tone or Fed Chair Powell's hawkish stance, as well as any hints from key data points, could attract arbitrage traders back to the market.
Omori said: "The Bank of Japan's pace of interest rate hikes will be very slow, and if Powell does not intend to cut rates quickly, the interest rate differentials will be very attractive for arbitrage trading."
The Japanese Ministry of Finance is not that aggressive; if they 'remain silent, investors will feel there is no reason not to engage in such trades.'
Article reposted from: Jin Ten Data.