Room for new funding
Despite the decision by the Bank of Japan to keep monetary policy all but unchanged, the market is still clinging to the prospect of monetary adjustment in the periods ahead. Following the initial reaction in USDJPY in the early hours of the morning, the remainder of yesterday’s trading session saw the Yen recover despite the lack of movement from the Bank of Japan. Given that Governor Haruhiko Kuroda is due to step down following the bank’s next decision in March, markets merely adjusted the pivot point for the BoJ further out in the calendar year. Critically, although headline rate and yield curve control policies remain unchanged, JPY swap points within FX remain well above their recent levels. The market’s defiance to heed the decision yesterday still leaves funding conditions less accommodative than perhaps the Bank would like. As a result, we could see a shift from the Yen as the funding currency of choice for investors.
The question is, which currency might they turn to? The Euro and Swiss Franc have typically been some of the only competitors to the Yen as the funding currency of choice. When investors want to take advantage of high interest rates and returns overseas, they typically source funding for such investments outside of the currency they will be investing in. If they were to borrow money within the same currency (or even commit their own capital held in another high yielding currency) returns would diminish. Instead, investors will borrow where money and credit is cheap and available and take a raw unhedged position on the FX risk. This creates selling pressure on the funding currency and buying pressure on the high yielding currency leading to opposing price pressures in the respective currencies. The funds transferred to the higher yielding currency and economy for investment exposure could be invested into simple interest rate products such as local government debt or be put to work in the local corporate bond or equity market for example.
Due to the post financial crisis era of ultra-low interest that we observed across most of the developed world, the choice for funding currencies was abundant. It was the search for high yielding currencies that was the challenge whilst even typically high-yielding emerging market currencies loosened central bank policy. Today it is the likes of the Brazilian Real reaping the benefits as the benefactor of many carry trades given its headline policy rate of 13.75%. The Mexican Peso with a policy rate of 10.5% is also deriving market demand from such trading patterns. On the funding side, it could be the Euro or Swiss Franc that remain viable options as substitute funding currencies to the Japanese Yen.
Whilst JPY may still remain the currency of choice at least for now to fund carry trades, the Swiss Franc, providing just 1% at the Swiss National Bank level, is a viable option. The Euro may have priced itself somewhat too far out of the market to be the funding currency of choice for many investors with rates at the ECB currently at 2.5% and expected to rise further. Following comments from the ECB this week, expectations for interest rates for the year ahead have taken a dent with key policy makers warning that policy rates many not need to go as far as the market is pricing. With more talk and action like this, the Euro could still remain a viable, albeit outside, bet as a competitor to the Yen. The conclusion is that if funding preferences for the carry trade do shift away from the Yen then there is room for JPY to strengthen further. In a high interest rate environment, investors are certain to keep their appetite to gain exposure to high yielding currencies and therefore it is only a matter of where they go to fund such trades. Those currencies that do begin to complete with the Yen more as implied rates rise will face increased selling pressure as investors take to the open market to sell these currencies in favour of higher yielding currencies.
Discussion and Analysis by Charles Porter
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