The Yen vs. Carry Trades

GBP/JPY

Key zone: 211.50 - 212.50

Buy: 213.50 (on a decisive break above 213.00); target 216.50; StopLoss 212.80

Sell: 211.00 (on strong negative fundamentals) ; target 208.50; StopLoss 211.70

The normalization of Bank of Japan monetary policy, currency interventions, and the threat of a stock market correction are creating conditions for a large-scale unwinding of short yen positions. A conflict is emerging in the foreign exchange market between the European currencies' continuing interest rate advantage and the growing likelihood of a sharp shift in market sentiment.

EUR/JPY and GBP/JPY remain attractive for speculative buying for now. However, further tightening of Japanese monetary policy and instability in equity markets are increasing the vulnerability of these positions.

A reminder:

A classic carry trade strategy involves borrowing in a currency with a relatively low interest rate and investing the proceeds in higher-yielding assets. For EUR/JPY and GBP/JPY, this means selling yen while simultaneously buying euros or British pounds. The outcome of these transactions depends not only on the interest rate differential but also on exchange rate movements.

The Bank of Japan has already raised its key interest rate to 1.25%, the highest level since 1995. However, the yen remains relatively weak because interest rates in the United Kingdom and the eurozone are still higher than in Japan.

• Following the BOE's 25-basis-point rate hike on November 5, the pound's nominal interest rate advantage over the yen reached 275 basis points.
• The ECB's deposit rate of 2.50% provides a corresponding advantage of 125 basis points for the euro.
• Further BOJ rate hikes will narrow these differentials, increasing JPY funding costs and reducing the potential interest income from the corresponding positions.

At its October meeting, the BOJ confirmed that it would continue reducing purchases of Japanese government bonds. The central bank's reduced presence in the debt market changes the supply-demand balance for JGBs and could make Japanese government bonds more attractive to domestic investors.

Additional arguments in favor of continued normalization emerged on October 30. The Bank of Japan acknowledged that underlying inflationary pressure had approached a level consistent with its 2% target. BOJ Governor Kazuo Ueda emphasized that decisions would be made at each meeting, including the December meeting, taking current inflation risks into account.

Another source of uncertainty was the Japanese currency intervention statistics published on November 9. The Ministry of Finance confirmed that ¥15.3993 trillion had been spent supporting the national currency over just three trading days during the summer. However, such measures do not eliminate the fundamental interest rate differential or guarantee sustained JPY appreciation.

Direct operations by Japanese authorities are usually concentrated in the most liquid instruments, primarily USD/JPY. Through arbitrage mechanisms, their impact quickly spreads to cross rates. For example, if EUR/USD remains unchanged, a 3% decline in USD/JPY

The combination of currency intervention and a large-scale equity sell-off remains particularly dangerous. Under such conditions, investors may simultaneously buy back yen to repay funding, liquidate risk assets, and reduce leverage. Initial JPY appreciation could trigger a chain reaction of forced position closures, accelerating declines in EUR/JPY and GBP/JPY.

So What Is the Outcome?

EUR/JPY and GBP/JPY are being influenced by opposing fundamental factors. The continuing interest rate advantage of the euro and pound supports existing positions, while BOJ policy normalization and the possibility of interventions increase the risk of a downward correction.

The base-case scenario assumes gradual yen appreciation but does not guarantee an immediate reversal in the cross rates. Further movements will depend on decisions by the Japanese central bank, actions by currency authorities, and the resilience of global risk appetite.

The main threat to traders lies in the asymmetry of potential outcomes. Sharp yen appreciation could wipe out interest income accumulated over many months in just a few hours.

The greater the concentration of speculative long positions in EUR/JPY and GBP/JPY, the more serious the consequences of even a relatively small initial move against them.

So we act wisely and avoid unnecessary risks.

Profits to y’all!