The fine print: Trade risks

The yield in the USD/JPY currency pair has gone from 2.25 percent in the beginning of the year to 3.25 percent as of July — with the possibility of going to 4 percent by November. This has made USD/JPY the hottest carry trade of the year. As long as the U.S. remains on track to raise rates while Japan’s rates remain unchanged, USD/JPY will continue to accelerate.

However, there are risks USD/JPY carry traders need to know about. Because the USD/JPY carry trade is contingent upon a continual tightening campaign by the Federal Reserve, traders need to watch the trend of U.S. economic data to ensure it supports the case for higher rates. For example, if U.S. economic data begins to turn sour because of weaker consumer demand (in the face of higher oil prices), the Fed may be forced to stop raising rates sooner rather than later, potentially capping interest rates at 3.75 percent instead of 4 percent.

Another possible risk is to the Japanese yen. China has announced on July 21 it was moving to a managed float against a basket of currencies, revaluing the yuan by a surprisingly small 2 percent. There is speculation that further revaluation may occur down the road, given the nominal size of the latest revaluation.

China, however, refuted their own statement by saying that even though Central Bank Governor Zhou Xiaochuan said this was an “initial 2-percent adjustment” and that they will gradually continue to reform the country’s exchange rate system, it was wrong to think that this was a first step that “warrants further actions in the future.” China stressed that “gradualism” is key and from the looks of it, they seem to be trying to convince the markets that gradualism will be done over the course of months or even years.

China’s move towards further renminbi convertibility is particularly important for Japan and USD/JPY. As seen, minutes after China’s announcement, USD/JPY slipped more than 200 points. Dollar/yuan (USD/CNY) forwards have a very close relationship with USD/JPY: Between 2003 and 2005 the correlation between six-month USD/CNY forward rates and USD/JPY was above 80 percent. Since the renminbi is not readily available for trading by individual speculators, many traders have opted to express their views through the yen instead. This suggests if there are any further announcements in the near term or if China releases the components of their managed float basket, USD/JPY could see an equally strong move, putting to risk the positions of those who are long USD/JPY for carry. In the meantime though, the Chinese government suggests otherwise.