The yen is a currency trader’s best friend and worst enemy

Shuli Ren, Bloomberg

There are two big problems in the world of currency trading.

First, those who engage in carry trades tend — to use Gavekal Research’s founder Louis-Vincent Gave’s words — “eat like a bird and poop like a cow.” This strategy, which borrows money in a country with low interest rates and then invests in one where you can get considerably higher returns, is a leveraged play. While it seems safe buying local government debt, a sudden change in exchange rates can reinforce, or dramatically derail, a trader’s payouts, leading to margin calls and flash crashes.

Second, the Japanese yen, undervalued by about 40% on a purchasing power parity basis, is a dangerous anomaly. As the currency hovers at 155 per dollar and former officials warn of possible interventions, a sharp rise in its value may create havoc from Mexico to Turkey.

Looking back, yen-funded carry trades have turned out to be among the most profitable plays this year. Of 20 major emerging markets currencies, all generated positive total returns, led by the Turkish lira’s 19% and Mexican peso’s 14%.

So how popular is FX trading among the Japanese, and will these retail investors be prone to panic selling? Are the Mrs. Watanabes, the archetypal retail investors who gained prominence in the early 2000s for their foray into currency trading, still around, or have they moved on to something else, say equities? Earlier this year, the government launched tax-free investment accounts to coax Japanese households to put their money into the stock market. Online brokers have seen a sharp increase in account openings since.

Unfortunately, we still have young Mr. Watanabes to worry about. Margin requirements are lower for emerging markets currencies, therefore making it easier for these first-time traders. Men in their 30s are the most active, with about 70% holding their portfolios for less than a week, data provided by Nomura Securities show.

The Mexican peso, in particular, is Mr. Watanabe’s favorite plaything. Turnover is high, bid-ask spread is narrow, and it’s a direct bet on the outcome of the US presidential election as well as immigration and border control policies. Indeed, investors got a taste of their power and what a flash crash might look like in mid-April, when news hit that Israeli missiles had struck Iran. Within minutes, the peso plunged 7.4% against the yen before recovering.

These days, emerging markets currencies are much calmer, especially compared to early 2020 when the pandemic hit, or during the Federal Reserve’s aggressive rate hike cycle in 2022. Ironically, this is not necessarily a healthy development. The seeming tranquility tends to lure inexperienced retail investors, in turn paving the way for sudden selloffs.

As a result, this is no time for developing nations’ central banks to sit back and relax. The currency world has not reached a steady state yet, as evidenced by the slumping yen. Lucrative carry trades can reverse overnight. Be on alert for a big cow-storm.

Courtesy Bloomberg/Shuli Ren