The Yen sets a trap for carry trades

GBP/JPY

Key zone: 211.00 - 212.00

Buy: 212.50 (on strong positive fundamentals); target 214.50-215.50; StopLoss 211.80

Sell: 210.50 (on a confident break of 211.00) ; target 208.50; StopLoss 211.20

Eurozone debt risks are weakening the euro, while the UK's interest rate advantage supports the pound. However, a shift in BOJ policy could trigger a rapid unwinding of carry positions and increase pressure on both currency pairs. The foreign exchange market is approaching a series of important signals from leading central banks, and the yen could become the main source of volatility.

The euro faces pressure from the eurozone's fiscal problems and uncertainty surrounding ECB policy. The pound appears more resilient thanks to higher yields on British assets, but this advantage does not guarantee protection against a sharp appreciation of JPY.

A quick recap:

Today, October 21, investors are focused on speeches by BOE Governor Bailey and ECB President Lagarde. Their comments on inflation, interest rates, and the economic outlook could reshape expectations for EUR/JPY and GBP/JPY. However, the key factor for both pairs remains not only the stance of European central banks but also the future trajectory of Japan's monetary policy normalization.

Central bank decisions could widen the divergence in currency performance:

• ECB — October 29. Investors are assessing the prospects for further monetary tightening amid inflation of 3.8% and growing concerns about the sustainability of public finances. Updated assessments of price pressures and financial stability will be particularly important. Political uncertainty in France and a high debt burden are increasing market sensitivity to borrowing costs and European bond yield spreads.
• BOJ — October 30. The main question is how consistently the central bank will continue normalizing policy and whether this can ensure sustained yen appreciation. If the BOJ moves toward tighter conditions while the ECB faces constraints on further rate hikes, the interest rate advantage of European currencies will narrow. In addition, JPY remains an important funding currency for carry trades, so falling stock markets, a spike in volatility, or reduced leverage could trigger demand for the yen even without an unexpected decision from Japan's central bank.
• BOE — November 5. Markets are considering the possibility of further monetary tightening and an increase in the benchmark rate to 4%. The UK policy rate currently remains at 3.75% — 250 basis points above the BOJ rate and 125 basis points above the ECB deposit rate. This supports the pound's appeal for strategies involving borrowing in a low-yielding currency and investing in higher-yielding assets.

Even a BOJ Rate Hike Does Not Guarantee Sustained Yen Appreciation.

The future performance of JPY will depend on how consistent developments in the Japanese economy and global financial conditions prove to be.

• Inflation. If wage growth continues to support consumption and domestic price pressures, the BOJ will have stronger grounds for further tightening. However, if inflation weakens, the scope for raising rates will narrow.
• Bond market. Rising JGB yields could make domestic instruments more attractive to Japanese investors and reduce the relative benefits of overseas investments. What matters is not only nominal yields but also currency hedging costs, which affect the ultimate returns on foreign assets.
• Global risk appetite. In a calm market environment, investors may continue using the low-cost yen to finance purchases of higher-yielding assets. However, if sentiment deteriorates sharply, these positions become a source of additional demand for JPY.

The Main Threat to Carry Trades Is the Simultaneous Unwinding of Positions and Accelerating Yen Appreciation.

If market participants begin exiting trades in which they sold JPY and bought higher-yielding currencies on a large scale, EUR/JPY and GBP/JPY could decline much more sharply than a typical reaction to interest rate changes. Closing these positions involves reversing the transactions: buying yen and selling currencies purchased with borrowed funds.

So What Is the Outcome?

Even if the BOJ tightens monetary policy, interest rate differentials may still favor the euro and pound. However, carry trades depend not only on the interest rate spread earned but also on exchange rate movements. Yen appreciation of just a few percent could wipe out a substantial portion of a strategy's annual return, especially if positions were opened using leverage.

The pound currently appears fundamentally more resilient than the euro, while EUR/JPY presents a more attractive pair for identifying short opportunities. However, the main idea is not to make an unconditional bet on yen appreciation against all currencies, but to exploit differences between the economic and monetary conditions of the eurozone and the UK.

• EUR/JPY: As long as prices remain below 178.20, selling on corrective rallies looks preferable to buying. The reaction to central bank meetings and movements in Japanese bond yields will be important for confirming this scenario.
• EUR/JPY: As long as prices remain below 178.20, selling on corrective rallies looks preferable to buying. The reaction to central bank meetings and movements in Japanese bond yields will be important for confirming this scenario.

Over the next four weeks, the preferred scenario is to look for opportunities to sell EUR/JPY near resistance levels. Buying GBP/JPY is justified only with technical confirmation and a continued interest rate differential favorable to the pound.

The main risk to both scenarios is faster-than-expected BOJ tightening or a sharp deterioration in global risk appetite.

So we act wisely and avoid unnecessary risks.

Profits to y’all!