Carry Trades, a blessing in disguise or curse: Impact on Asia’s biggest economy’s currencies, Yuan, Yen

By Amit Pabari-

They say, “Buy low, sell high” and that’s what is the rule for carry trades too. Typically, the carry strategy involves borrowing a low-interest-rate currency and converting the borrowed amount into another currency offering higher interest rates.

The Math

To simplify, how would you feel if you get to borrow money at nearly 0% cost and have an opportunity to invest in the assets fetching say 5%? Well, that’s what exactly happened “before”  the interest rates in the US began to rise last year. Money was available cheaply at nearly 0.25% cost and the same was invested by the investors in the EM countries where they would easily enjoy an arbitrage gain of around 4% for countries like India. These investments could be deployed in any assets like CDs (Certificates of deposits), government bonds, equities, etc. Of course, other factors are considered like the central bank’s stance, currency stability, currency valuation, domestic fundamentals, etc.

The central banks and their twist

Well, the rosy picture was quickly blurred, and the petals started to fall off when the central bank across began rising ultra-low interest rates to sky-high levels, to fight decades-high inflation.

Country Interest rate
Interest Rate 
Absolute change (%) Spot Rate
Spot Rate
Relative change (%)
US 0.25           3.25 3.00 97.40             112.10 15
EUR Zone 0.00           1.25 1.25 1.1100           0.9800 -12
UK 0.50            2.25 1.75 1.3300           1.1160 -16
China 3.70            3.65 -0.05 6.30                   7.16 -14
Japan -0.10          -0.10 0.00 115.00           144.75 -26
India 4.00            5.90 1.90 75.75               81.50 -8
“Chuck the fundamentals, and get the sentiments”, says the market now.

Formulae: Higher rate + Hawkish Stance = Higher Carry and Higher Currency valuation

If we are to take the example from the cluster, at the beginning of the hiking cycle, the carry trade had turned in favor of the US as the Fed began hiking rates and was quite hawkish in its stance as the inflation kept increasing till the second half of 2022. Hence, the pace of hiking coupled with the future expectation by the market, kept the dollar got benefitted amongst the lot and it moved higher by 15%.

Country Interest rates in March 2022    
Interest rates in Sept 2022
Absolute change (%) Spot Rate
Spot rate
Relative change (%)
US 4.50           5.25 0.75 103.50   102.80 -1
EUR Zone 2.50          4.00 1.50 1.0700   1.0900 2
UK 3.50            5.00 1.50 1.2100   1.1270 5
China 3.65           3.55 -0.10 6.92          7.25 -5
Japan -0.10          -0.10 0.00 131.00   144.50 -10
India 6.25           6.50 0.25 82.70      82.00 1

However later, since there were rising expectations of the Fed pivot, the DXY weakened and the carry got in favor of the EM countries. The highest benefiter was Mexico’s peso which has notched up carry-trade gains of 18%, while Hungary’s forint returned 15.4% and Brazil’s real 14%, also majorly as their currencies got appreciated.

Overall, to put it in numbers, the EM carry trade index, funded by short positions in the dollar, had an average gain of nearly 4.7% in H1 2023. With respect to other EM markets, India received 48.7 percent of total emerging markets FPI equity flows in 2023-24 as against India’s weight in the MSCI Emerging Market Index of 14.3%.

Well, carry is the king, and one cannot fight it, gain it, lose it, or retain it until it decides by itself.

What next?

However, there are growing expectations of the Fed hikes at least twice (50bps in total) this year and keep rates higher for longer which would then gain the US Dollar an edge over the currencies like Rupee, Chinese Yuan, Japanese Yen, etc.

On the other hand, as observed, the inflation across major EM countries has begun to decline and is lower trending, many of the central banks have opted for a rate pause. If emerging- market currencies do weaken with the start of monetary easing, it could swiftly reverse the flows.

Lower interest rate differential >> negative carry >> more foreign outflows >> weaker currency

Will the Yuan survive the Fed hikes?

Post covid, the wind for China seems to have changed, from one of the fastest growing economies to one just on the brink of slides into Deflation.

Core inflation slowed to 0.4% whereas the producer prices have been in the reds since Q4 2022 where the June slide was at the deepest pace since December 2015, adding to the evidence that the recovery is weakening.

Growth in 2022, was expected to be 5.5% but fell short at 3%, it’s the lowest in distant memory if the Covid-hit 2020 is exempted. This could be attributed to the lack of domestic demand and private investment, where the latter has fallen for the first time in a decade.

In an economy that is substantially driven by the housing market and exports, both sectors have seen deep wounds. New housing in January-April fell by more than 20% and exports have fallen in six of the last eight months. Imports too are down.

This is despite the monetary easing and the fiscal support provided. While the US and central banks elsewhere have been jacking up interest rates, China has been easing up on monetary policy. Going further too, the Bank of China would be compelled for further easing due to dented economic data and slowdown which has hurt the Yuan already. Hence, the slide up to 7.35-7.40 from the current 7.25 is much more likely to happen in the coming months despite PBOC intervention if one must go by the math.

The BoJ’s struggle to keep up with the Yen…

A decades-long deflated country has finally seen some consistent inflation in the recent pastJapan’s economy expanded at a faster-than-expected pace boosted by consumption.

Following, a technical recession at the end of last year, the GDP expanded at an annualized pace of 1.6% in the first quarter of the year. The better-than-expected result is likely to keep speculation alive that the Bank of Japan may start normalizing its policy after a decade of aggressive monetary easing. However, looking at the nation’s ballooning debt to GDP which stands at 264%, raises questions about its ability to repay it if the interest rates go high.

While on the surface, Inflation in the world’s third-largest economy, Japan, has been rising for more than a year, people’s buying power continued to fall in real terms. The regular wages have gained the highest since 1995 but the real wages outstripped by inflation are in contraction and household’s buying power has been squeezed.

In the given scenario, the BoJ going out of the league for a policy change from the current ultra-loose stance is not likely in the seen future. Hence, this keeps the sword hanging on the JPY which has bled this year. Being protected around the 145 marks with the verbal intervention by BoJ, how far will it remain resilient? In the absence of intervention or otherwise, if the 145 is taken out in USDJPY, the last year’s high of 150 can be touched, further having the potential to move towards 155 levels.

Amit Pabari is Managing Director at CR Forex Advisors. The views expressed in this article is his personal views.