By Alun John

HONG KONG (Reuters – The Bank of Japan is defending its position as a lone gove in its peer group, and the yen has reclaimed its title as the global most beloved funding currency.

However, the trade has risks. If tensions in Ukraine escalate or if the Federal Reserve acts aggressively, then the yen might revert to being an asset of safety.

The traditional role of the yen as a cheap currency that investors could borrow to finance trades in higher yielding markets, was slightly diminished by the coronavirus pandemic. Other central banks also cut rates to zero.

However, it has been reaffirmed as the preferred financing currency of choice this week following a BOJ special bond-buying operation that reminded markets of the BOJ’s commitment to keeping yields lower for longer.

This is in direct contradiction to the Fed and European central banks that are hawkish on inflation.

Ben Shatil is a JPMorgan FX strategist based in Tokyo.

“And that’s a situation that has traditionally favoured carrying trades the yen for funding.”

For the yen, some things aren’t changing. Japan is one of the most vulnerable currencies in the Group of Seven, with sub-zero rates for short-term returns and an investor base desperate to return abroad.

However, the Ukraine factor aside, it has made shorting the Japanese yen more risky.

In the event of increased energy prices, and possibly rising import inflation, it might be necessary for the BOJ raise rates. There is also the risk that the Fed may go too far in tightening policy, leading to global selling and flows into safe haven currencies.

A typical carry trade involves investors borrowing the Swiss franc or low-yielding Japanese yen to make investments in other higher yielding assets. The key is to keep the price of trades down by ensuring stability in the financing currency.

Short-term yen deposit rates in Japan’s deflation-stricken country have hovered around zero for the past decades, but they are now near zero since 2016, when the BOJ implemented its yield-curve management policy.

Borrowing yen for Brazilian money markets is one example of a typical carrying trade. This trade has yielded an average 10.7% annually so far in this year.

Paul Mackel is the global head for FX at HSBC. He says that investors could be going back the yen to fund their investments, however it can prove risky.

Mackel explained that while a carry trade may not be perfect, it is always about making pennies and getting in front of the steamroller. But, given political uncertainty, Mackel believes that this steamroller could be a bit closer.

If Yen is APPRECIATED

The yen is rising as the United States warns about Russian force buildup at the Ukrainian border.

It has risen sharply from 116.33 to 115.33 dollars, after testing its four-year low of 116.33 last week. Carry trades that involve selling short the financing currency are affected by this rapid appreciation.

“The yen’s safe haven properties can kick into gear very fast,” Mackel said.

A weakening yen could also cause concern in Japan, especially since the majority of the country’s energy comes from imports and the oil price is at its highest level for seven years.

As inflation has slipped closer to the BOJ’s 2% policy goal, there are more chances that the BOJ will lose its grip on yields. Rising yields also threaten yen funded trades.

Markets remain a mystery to the BOJ. To underline its determination to reduce domestic borrowing costs it offered to purchase unlimited bonds, but it made it clear that such offers would only be made sporadically.

At the moment, investors have bought into this dovish outlook.

JPMorgan’s Shatil explained that BOJ’s proposal to purchase bonds will “probably quieten down what had been quite a loud choir of people saying the BOJ would relent in yield curve control.”

This allows for the “creation of a runway to a little yen weakness that would be beneficial in context of these carry tradings.”