Yen arbitrage trading—a highly popular investment strategy this year—is making a comeback.
According to an analysis by Bloomberg of data from the Japan Financial Futures Association, Tokyo Financial Exchange, and the U.S. Commodity Futures Trading Commission, Japanese retail investors, as well as leveraged funds and asset management companies abroad, 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 in the yen.
Due to the large interest rate differential, increased borrowing by the U.S. government, and relatively low volatility in the money markets, these bets are expected to increase next year. Under these conditions, borrowing in Japan and then investing the funds in 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 trades is volatility."
Strategists from Mizuho Securities and Saxo Markets say arbitrage trading may return to levels seen earlier this year after investors suddenly exited this trade following the Bank of Japan's rate hike in July. It is worth noting that Trump's return to power could stir turmoil in the currency markets.
The widespread adoption of this investment strategy could impact global markets. The unwinding of yen arbitrage trades this summer wiped out about $6.4 trillion from global stock markets in just three weeks, with the Nikkei 225 experiencing its largest drop since 1987. Last week's sudden surge of the yen highlighted the ongoing risks faced by investors who are re-entering arbitrage trades.
Interest rates are the driving force behind this type of trade. The average yield of 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.
Although the Bank of Japan is gradually raising interest rates, the yield differential with major economies like the U.S. remains significant. The Fed cut rates by another 25 basis points in November, bringing them to a range of 4.5%-4.75%. Felix Ryan, a foreign exchange analyst at the Australia and New Zealand Banking Group in Sydney, believes that even if Japan raises rates to around 1%, the logic of arbitrage trading remains reasonable.
The strategy has been very profitable. Since the end of 2021, yen arbitrage trades targeting ten major currencies and emerging market currencies have yielded a return of 45%, compared to only 32% for the S&P 500 when accounting for dividend reinvestment.
This has attracted an increasing number of arbitrage investors, with yen short positions reaching $21.6 billion at the end of July (just before a massive unwinding).
Charu Chanana, chief investment strategist at Saxo Markets, said, "The Bank of Japan's rate hikes are unlikely to be sufficient to narrow the yield differential between Japan and the U.S. Given that U.S. debt and fiscal conditions are clearly a top concern for the incoming Trump administration, yen arbitrage trading may still have room 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.
Concerns in the market have eased since Trump nominated Scott Bessent as Treasury Secretary. However, Shoki Omori, chief strategist at Mizuho Securities Japan, believes that Trump will ultimately determine U.S. fiscal policy.
"Ultimately, it all comes back to Trump," Omori said, believing that arbitrage trading could return as early as January next year. "People forget the power risk that Trump poses to Bessent. If Bessent wants to stay on, I don't think he will be so rigid on budget issues."
The trade war threats 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 trades due to the country’s interest rates reaching double digits, Trump's comments could create enough volatility to make this trade less attractive.
This is important because arbitrage trades financed in yen benefit from lower volatility in the forex market. A JPMorgan measure of currency volatility has fallen from post-pandemic highs, despite rising uncertainty over Trump's new administration and escalating conflicts in Ukraine.
Volatility in the global forex market remains low.
However, some believe that the narrowing of the interest rate differential will keep momentum for arbitrage trades 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 the yen has seen sharp one-way fluctuations since late September.
Due to ongoing structural issues such as massive capital outflows, the yen has performed the worst among G10 currencies this year. Although the yen briefly rose to the 140 level against the dollar a few months ago amid a backdrop of unwinding interest rate 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 interventions, and statements from Bank of Japan Governor Ueda have kept market concerns about a December rate hike alive. While arbitrage trades have gained further support, 'this should ensure that arbitrage trades lack significant confidence and momentum in the spring of next year.'
Ahead of the December meetings of the Bank of Japan and the Federal Reserve, investors may gain further insights into arbitrage trades. Ueda's dovish tone or Fed Chairman Powell's hawkish tone, along with any hints from key data points, could attract arbitrage traders back to the market.
Omori said, "The pace of interest rate hikes by the Bank of Japan will be very slow, and if Powell does not intend to quickly cut rates, the interest differential will be very attractive for arbitrage trades."
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 shared from: Jin Shi Data