Amid rate cuts, do carry trades still work?

Executive summary

• As the Federal Reserve begins cutting rates, structural drivers of currency markets are shifting.
• We believe the Japanese Yen (JPY) may no longer be a suitable funding currency. Instead, we suggest considering a long position in the JPY, as interest rate differentials are anticipated to narrow from both ends.
• Risk management is needed for existing Swiss Franc (CHF) carry trade positions as we see medium-term bullish risks in the currency. The Chinese Yuan (CNH) presents a relatively more appealing option, characterized by structural bearish risks and lower volatility.
• Overall, the returns from carry trades are expected to diminish as central banks of high-yield currencies begin cutting rates. We think it is prudent to consider a partial reallocation of funding back to an investor’s base currency.

Throughout 2024, the dynamics of funding currencies and carry trades have taken center stage in the foreign exchange market. With interest rates elevated across the U.S. dollar and many G10 currencies, investors have increasingly turned to specific lower-yielding currencies as funding sources. This shift has resulted in notable market volatility over the summer, raising critical questions about carry trade strategies and the selection of funding currencies.

At this juncture, the global interest rate landscape is undergoing major shifts. The Federal Reserve delivered its first interest rate cut in four years at the September meeting, while several major European counterparts initiated similar actions earlier this year. What implications does this hold for investors? Do carry trades still work?

In this analysis, we explore the concept of funding currencies and carry trades, assess the outlook for popular funding currencies, and discuss the implications for investors. Particular attention will be given to three prominent funding currencies: the Japanese Yen (JPY), Swiss Franc (CHF), and Chinese Yuan (CNH).

Funding currencies and carry trades

In the foreign exchange market, currencies are often expressed as currency pairs, such as EUR/USD or JPY/USD, expressing the value of one currency relative to another. All FX trades involve the simultaneous purchase of one currency and the sale of another. The term "funding currencies," or "funders," refers to currencies that investors borrow and sell   to finance investments denominated in other currencies.

Funding currencies have several key characteristics:

• Interest Rates: Funding currencies are typically characterized by low interest rates, making it less costly to borrow.
• Exchange Rate expectations: Appreciation of the funding currency can lead to losses as the borrower would need to pay back more at the end. Therefore, currencies with stable exchange rates or even depreciation pressures usually work better as funders.
• Liquidity: Liquidity is also important as it ensures that large transactions can be executed without significantly affecting market prices, allowing investors to enter and exit positions easily. The cost of trading, i.e., the bid-ask spread, is also lower with better liquidity.

Borrowing lower-yielding currencies and reinvesting the proceeds in higher-yielding currencies/assets elsewhere, with the aim of profiting from the interest rate differentials, is called a carry trade. Over the first half of this year, traders relied heavily on carry trades given wide interest rate differentials, and low volatility in the FX market. This led to a massive buildup in carry trade positions, one of the largest in decades. A significant portion of these positions was funded with JPY, the only major currency with interest rates near zero at that time—estimates of JPY-funded carry trade positions ranged from USD 2 to 20 trillion at the peak. Some positions also used the Swiss Franc (CHF), offshore Chinese Yuan (CNH), and the Euro (EUR) as funders.

These carry trade positions started to quickly unwind since July 10th (when the Bank of Japan intervened in currency markets) and accelerated after the BOJ’s unexpected rate hike on July 31st. On August 5th, the TOPIX index lost 12% and the Nikkei volatility index spiked to crisis levels as investors liquidated equity positions in a rush to close out carry trade positions and deleverage. As of mid-August, the JP Morgan Investment Bank estimated that 65-75% of global carry trade positioning had been unwound. All widely used funding currencies sharply appreciated over the period, led by an over 10% move in USDJPY.

The carry trade unwind took place at a time of large shifts in the macro and policy outlook. While the peak impact of this episode seems to be behind us, the global interest rate landscape is just at the start of major shifts. Can investors still engage in carry trades? What is our preference for different funding currencies? Let’s take a closer look at the individual funding currencies. 

The Japanese Yen (JPY)

The Yen has a long history of being used as a funding currency and is also the biggest funding source for carry trade positions accumulated this year. This is primarily due to Japan’s prolonged period of zero/negative interest rates. In addition, ample currency liquidity added to the currency’s reliability as a funder.

Historically, there have been several episodes of carry trade-induced volatility. As shown in Chart 2, the JPY usually weakens during the build up of carry trade positions and strengthens sharply during their reversal. The same has happened this year. USDJPY has been overshooting our fair value model since Q2 due to a rapid increase in carry trade positions. These episodes aside, the JPY is usually easy to model—interest rate differentials have historically driven the majority of moves in the currency. Chart 3 shows the close to linear correlation between USDJPY and 10-year government bond yield differentials for most of the past three years.

Looking ahead, the stability of JPY carry trades has clearly declined. The Japanese authorities made it clear in July that they would manage excessive yen speculation more proactively, using a combination of monetary policy and direct FX interventions. This should discourage traders from rebuilding those positions on a large scale. At the current level, our model indicates that price distortions from carry trades have largely been squeezed out, as shown in Chart 4. Moves in USDJPY will likely return to tracking its traditional drivers, with interest rate differentials back in the driver’s seat.

We expect moderate appreciation of the yen over the next 12 months. Interest rate differentials will likely be squeezed from both sides—rate cuts from the Fed as well as continued BOJ policy normalization. US rate cuts will drive most of the moves as the Fed dials back its highly restrictive monetary policy to more neutral levels. In terms of the BOJ, we expect it to return to a gradualist approach as the risk of “excessive yen weakness” seems to be behind us. Domestic growth and inflation are showing signs of weakness lately, and Japan is not exempt from geopolitical and tariff-related risks. That said, policy normalization will likely continue, albeit at a gradual pace. Over the longer term, the yen also appears significantly undervalued versus its fair value based on purchasing power parity.

Bottom Line: Given the heightened volatility and potential for appreciation, it is advisable to reduce or avoid using JPY as a funding currency. Instead, clients can consider taking a long position in JPY to benefit from its expected moderate appreciation over the next 12 months.

The Swiss Franc (CHF)

The Swiss Franc ranks as one of the most actively traded currencies globally, positioned seventh in terms of trading volume. Its appeal as a funding currency is primarily due to its low interest rate environment. The Swiss National Bank (SNB) has adopted a cautious approach to interest rate hikes during the inflationary period of 2022-2023, with a terminal rate of 1.75% that remains notably lower than that of most G10 peers. In fact, the SNB was the first G10 central bank to embark on an easing cycle, implementing its initial rate cut in March. This decision was facilitated by a smooth disinflation process in Switzerland throughout 2023, which concluded the year below target, despite emerging stress within the domestic economy.

Similar to the Yen, the interest rate differential is a critical factor influencing the CHF's outlook and its viability as a funding currency. In this context, the CHF may be more advantageous than the JPY, as the SNB is expected to continue its accommodative policies, thereby sustaining a favorable carry trade environment. Recent PMI data indicate a weakening domestic economy, with both manufacturing and services indices falling below the pivotal 50 mark. Weakness in business capital expenditure has further hampered growth prospects. The market anticipates two additional 25 basis point cuts before year-end, leading to a mixed outlook for USDCHF exchange rates. While both central banks are likely to pursue rate cuts, the narrowing of interest rate differentials may favor the CHF in the medium term, particularly as the Federal Reserve’s rate cutting cycle is expected to extend due to its higher initial rates.

In addition to interest rate dynamics, the CHF is influenced by several other factors:

• Safe Haven Demand: The Swiss Franc is widely regarded as a safe haven asset, benefiting from Switzerland's stability and neutrality. It typically experiences inflows during periods of economic or political uncertainty in Europe. A notable correlation exists between EURCHF and Eurozone growth revisions, with the Franc tending to appreciate when European growth falters.
• SNB Intervention: The Swiss National Bank actively manages the foreign exchange market. Throughout 2023, it consistently intervened to bolster the strength of the CHF as part of its strategy to mitigate inflationary pressures. As Swiss inflation has significantly declined below the 2% target and domestic growth shows signs of weakening, the SNB may, in contrast, adopt a less tolerant stance towards a strong CHF and consider purchasing foreign currency at some point.

Bottom Line: Risk management is needed for existing CHF carry trade positions. Investors can consider right sizing the positions during windows of CHF weakness, or adding partial hedges to mitigate risks. Over the next 3-6 months, tactical  opportunities may still exist as the SNB will likely try to stem the strength of the currency. That said, medium-term CHF bullish risks can’t be ignored as the Fed’s cutting cycle will likely be deeper than the SNB’s, European growth could surprise to the downside, and safe haven flows could increase on potential geopolitical flare-ups.

The Chinese Yuan (CNH)

Unlike the long-established histories of the Japanese Yen (JPY) and Swiss Franc (CHF), the Chinese Renminbi (CNH) has only recently emerged as a funding currency, and its characteristics remain relatively unfamiliar to many investors. For a long time, the CNH enjoyed a positive carry relative to developed market (DM) currencies, similar to many of its emerging market peers. However, this reversed in 2022 as developed economies aggressively raised interest rates in response to a global inflation surge, while China continued its monetary easing cycle. As shown in Chart 9, CNH interest rates are meaningfully lower than most of the major currencies.

As a funding currency, the CNH presents distinct advantages and disadvantages. From an interest rate perspective, we anticipate that Chinese rates will remain lower for an extended period due to prevailing domestic macro conditions. This scenario suggests that the carry on the CNH against major currencies will likely remain negative for some time. Another notable advantage of the CNH is its low volatility; historically, the CNH has exhibited one of the lowest volatilities among major global currencies due to its quasi-peg. As illustrated in Chart 10, its implied volatility has been significantly lower than that of the other two funding currencies discussed. This stability is largely attributable to active management by the Chinese central bank, which maintains a low tolerance for one-sided currency volatility and proactively employs interventions to counteract it.

While the stability of exchange rates is a considerable advantage, frequent interventions can introduce certain drawbacks. Some intervention measures involve liquidity drains in the offshore CNH market, which can lead to volatility in funding costs, particularly for shorter tenors. Additionally, liquidity remains a concern, as the scale of the CNH market is still limited, with daily turnover considerably lower than that of the JPY and CHF.

Looking ahead, although declining USD rates may mitigate the CNH's carry disadvantage, several idiosyncratic factors prompt us to maintain a bearish outlook on the currency:

• Balance of Payment Challenges: Overall China sentiment remains subdued due to a bumpy economic recovery, resulting in limited capital inflows and persistent outflows. While exports have performed robustly, the outlook is complicated by geopolitical risks.
• Geopolitical Overhang: Potential tariff risks and broader geopolitical concerns could weigh on the currency. The Yuan depreciated meaningfully over the course of the 2018-2020 US-China trade war.

Given these challenges, we expect the CNH to benefit the least from the global rate cuts compared to the other two funding currencies. The recent strength of the CNH has enabled the People's Bank of China (PBOC) to reduce interventions, stabilizing funding costs at low levels. While repatriation flows from exporters may be larger than in the previous two years, we do not anticipate these flows to be substantial enough to foster significant appreciation of the CNH, especially given the ongoing negative carry.

Consequently, we rank the CNH favorably among the three currencies as a potential funding source. Investors with natural long exposure to CNH—such as those holding yuan-denominated Chinese assets—may consider utilizing CNH as a currency hedge in their funding strategies.

Conclusion

Given the evolving global interest rate landscape and the specific characteristics of each funding currency, investors may need to be more selective regarding taking FX risks in their funding strategies. The following actions can be considered:

1. Revaluate the use of JPY as a funder for carry trades: Due to potential appreciation risks and increased volatility, it might be prudent to reassess the use of JPY as a funding currency. Considering a long position in JPY could be beneficial if its appreciation is expected.
2. Implement risk management for CHF positions: While the CHF remains a viable funding currency, it is crucial to right size the positions and/or add partial hedges to mitigate potential appreciation risks. Monitor SNB interventions and safe haven demand closely.
3. Consider CNH for those with hedging needs: The CNH's low volatility and structural bearish risks may make it a more appealing funder than the other two. In particular, investors with natural long exposure to CNH might find it useful as a currency hedge.
4. In general, it is prudent to consider a partial reallocation of funding back to the base currency, as returns from carry trades are expected to diminish with the commencement of rate cuts by central banks of high-yield currencies.

It is important to note that currency and hedging strategies carry inherent risks, and investors should carefully evaluate these risks in the context of their overall investment objectives and risk tolerance.