The US dollar, often expected to take the top podium in the ongoing competition of currencies, has found itself ousted by a recent underdog. After reaching its 2024 high in early July, the dollar index (DXY) - which measures the dollar's strength against a basket of major currencies - has been on a downward trend. By early August, it had dipped below 104 for the first time since March, marking a significant 3% decline over just a few weeks.
The primary culprit in this upset matchup? Japan.
The Yen's Revenge
The Japanese yen has been the primary beneficiary of the dollar's weakness. After hitting a 38-year low against the dollar in late June, the yen has staged a remarkable comeback, regaining 10% in just a few days. This resurgence is largely due to the unwinding of what's known as the "carry trade."
Understanding the Carry Trade
For the past four years, investors have been taking advantage of Japan's persistently low interest rates to establish large "carry trade" positions. This strategy involves borrowing yen cheaply and investing in higher-yielding currencies, profiting from the interest rate differential. Here's a simplified example of how a JPY/USD carry trade works:
1. An investor borrows 10,000,000 JPY at 0.1% interest rate
2. They convert this to USD at an exchange rate of 150 JPY/USD, getting $66,666.67
3. They invest this in US bonds yielding 4%
4. After one year, they earn $2,666.67 in interest (4% of $66,666.67)
5. They now owe 10,010,000 JPY (principal plus 0.1% interest)
If the exchange rate stays the same, or if the yen weakens, they would make a profit of about $2,600 (minus transaction costs). This widespread practice led to an extremely weak yen, with the USD/JPY rate recently hitting 161.80, a level not seen since 1986.
Unwinding the Carry Trade
Traders engaged in the carry trade find themselves in a position similar to short-sellers. They've borrowed Japanese Yen, which they'll need to repay at a future date. When that time arrives, these traders must sell the US Dollars they acquired and use the proceeds to settle their Yen debt. This process of closing out the position by converting back to the original currency is known as "unwinding a carry trade."
Well, the time has come to pay the piper. This persistent weakness prompted The Bank of Japan (BOJ) to take action to strengthen its currency by selling dollars and buying yen (increasing yen demand) and adjusting interest rates upward (further increasing yen demand). Well, it worked, perhaps better than the BOJ even expected.
This intervention prompted investors to rapidly exit their carry trade positions, like a short-seller covering their short, causing the yen to surge. As of Monday, August 5, the yen had appreciated over 10% from its low against the dollar. Some high-yielding currencies suffered even bigger losses against the yen, particularly the Mexican peso, which lost 20% during July alone.
This dramatic unwinding of the carry trade has been a key factor in the yen's remarkable comeback, transforming it from a long-time underdog to a formidable contender in the currency markets.
The Final Fed Factor
Now, couple the BOJ's recent moves with the US Federal Reserve's stance on interest rates, the relative decline of the dollar to yen starts to add up. While the Fed keep rates steady at its latest meeting, Chairman Powell hinted at potential rate cuts in September. This, combined with a weak US employment report, has led markets to expect lower interest rates, which typically weaken the dollar. With higher JPY interest rates and potentially lower USD rates, this shift in USD/JPY could just be the beginning.
Takeaways
1. JPY: It appears that most of the highly leveraged carry trades have now been unwound, suggesting the yen may become less volatile in the coming weeks. However, since the BOJ is still holding rates well below those of other industrialized nations, any additional yen appreciation is likely to be gradual.
2. Long-Term Dollar: The dollar's current weakness may signal the start of a new long-term trend. Historically, the dollar has undergone multi-year cycles of strength and weakness. While a dramatic collapse is unlikely, those with dollar exposure should consider some protective strategies.
3. Short-Term Dollar: Keep an eye on the psychologically important 100 level for the dollar index. A monthly close below this level could confirm the beginning of the longer-term downtrend mentioned above.
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