Imagine that you’ve been borrowing from a specific bank for years because they give you lower rates. Now, all of the sudden, a new bank comes into town and offers even lower rates.

Would you switch banks? I would!

But of course I’m not really talking about banks. I’m talking about currencies.

The new bank in town offering a better deal is the U.S. dollar. And the bank that’s losing market share in the Japanese yen.

Who would have thought? In the last few weeks, one of the traditionally weakest currencies has proven to be one of the outperformers in the FX world. Even the recent rally of the dollar hasn’t done much damage to the yen.

The Dollar, the New “Cheapest” Currency

Before last year’s global recession, Japan was the only country in depression.

For that reason, national banks viewed non-Japanese accounts as less risky. So they’re happy to lend their money abroad. Foreign institutions were also happy to borrow yen from Japanese institutions at lower rates.

This win-win situation made the yen carry trade very popular in the last years.

But now that other countries have joined the deflationary club, Japanese banks have started to change their strategy.

Japanese banks no longer perceive non-Japanese accounts as “safer.” So the carry trade is no longer a good deal for Japanese banks. They now prefer to invest within the country.

Now foreign institutions can also find a better deal elsewhere. The U.S. dollar LIBOR rate (the rate banks charge each other for overnight loan) is now more comparable to yen rates. This is a big incentive for institutions to borrow in dollars rather than in yen.

Japanese Investors Jump into the Mix

Japanese investors are another big engine behind this new carry trade dynamic. It’s now cheap for Japanese investors to hedge overseas FX risk. Let me explain.

When Japanese institutions invest in U.S. dollar denominated assets, they become exposed to Forex risk. More specifically, they risk the fact that the dollar will fall against the yen and their assets will lose value.

So how can they reduce that risk? They can make their liabilities also dollar denominated. In other words, they can borrow dollars to finance their investments.

But before the crisis, the higher rate differential between dollar and yen loans made this “dollar insurance” pretty expensive.

Now that the rates are pretty comparable, Japanese investors have a cheap way to hedge their FX risk. The graph below shows a clear correlation between the lower rates in U.S. and the recent yen appreciation.

The Japanese Yen Closely Tracks LIBOR…


Dollar Carry Trade Short-Term Phenomenon

But the most interesting question is how long this new carry trade scenario will last. Will the dollar replace the yen as the new funding currency permanently?

Probably not!

You see, deflation is a much bugger issue in Japan. Despite near zero rates and massive government stimulus, consumer prices fell a record 2.4% in August from a year earlier.

So this deflationary environment will prevent the Bank of Japan from increasing rates anytime soon.

The Federal Reserve is more likely to increase rates first. And when that happens, the yen will likely give up most of its recent gains and will once again become the favorite currency for carry trades.

But we won’t see that until next year. Bernanke will have his hands tied for quite some time. The combination of rising unemployment, high debt levels in the household sector, and weak bank lending capacity will force the government to keep rates low.

As a result of this policy, the dollar will continue to lose value. And as you know, weak currencies that offer low rates are the best candidates for funding investments in higher yielding currencies. So for now, the dollar will continue to be the preferred currency for carry trades.

The only thing that can save the dollar from being the new funding currency in carry trades is a collapse on the equity market. But if that happens, the Yen will also benefit from risk aversion flows. In other words, scared investors running for cover isn’t enough to push the Japanese yen down either.

Bottom line: Watch for the dollar to remain the cheapest carry trade currency for some time still. Till then, the yen will reign.

Best Regards,
Evaldo Albuquerque

EDITOR’S NOTE: For years, traders held down the yen’s value by using it as the borrowing currency for the carry trade. The same will happen with the dollar. This is just one of many trends that are working against the U.S. dollar long-term. To find out more, read our special report on the 3 Strikes for the Dollar here.