Mrs. Watanabe’s (Japanese retail’s) yen carry trade

Blaming the carry trade

Since the second week of July, the yen has surged over 10 percent against the dollar. Catalysts for this include suspected interventions on July 11-12, followed by political jawboning, the BOJ and Fed actions, along with equity sell-offs. The unwinding of the yen carry trade, which is the focus of this report, is also cited as a reason for this surge.

These events reportedly led international investors to shift from multi-month highs in net purchasing to three consecutive weeks of net selling Japanese equities, as illustrated in the next graph. The first week of selling followed the suspected interventions on July 11/12 and coincided with some jawboning on July 17. The second week aligned with a correction in U.S. tech stocks and heightened U.S. political uncertainty. The third week saw a hawkish BOJ hike, a dovish FOMC, and a weak U.S. employment report, including a recession warning based on the Sahm Rule. International sentiment often dictates Japan’s market direction due to the large share of international investors, especially in the equity index futures market.

Mrs. Watanabe basics

The carry trade is notoriously difficult to measure but is believed to have both an institutional element and a retail element. In this post, we will focus on the retail element, which is less understood outside of Japan.

Foreign exchange markets have 2 counterparty categories. The interbank market, where dealers trade with other dealers, and the influential dealer-to-customer or customer market. The interbank market is used to “cover” or reduce unwanted positions arising from the customer market (BOJ, Feb 2023). Spot-market trading, the simple trades that settle within 2 days, comprise the bulk of total volume.

In Japan’s case, the popularity of foreign exchange margin trading, known as “FX”, appears to have made “FX” firms the largest spot trader in the customer market¹. “FX” trading is predominantly driven by Japanese retail investors, known as “Mrs. Watanabe” abroad². The next graph, with labels used by BOJ research in June 2023, imply Mrs. Watanabe’s trading in Japan’s spot market is larger than institutional investors, non-financial corporates, and even hedge funds³. Similarly, a triennial survey by the Bank for International Settlements (BIS) noted that Japan’s “FX” market is the largest retail-driven foreign exchange market in the world.

Why is “FX” so popular in Japan?

The post-pandemic weakening of the yen in 2022 caused the “FX” market to grow sharply, as shown in the next graph, with nearly 90 percent of volume involving the USD/JPY pair, the second-largest currency pair in the world according to the BIS. Since 2022, “FX” volume has remained high, averaging about 1 quadrillion yen a month, or approximately 7 trillion dollars.

Several factors contribute to the growth of “FX” in Japan:

1. Cheap and liquid: Often, fees are cheap or effectively “free”, allowing for day trading and even “minutes trading” according to BOJ research – trading within the same minute. Major firms allow 24-hour trading on smartphone and PC apps. BOJ research noted that an estimated 80 percent of all “FX” trading is less than a day.
2. Highly leveraged: Maximum leverage can reach as high as 25⁴ times, with some “FX” firms allowing trades starting from 100 yen (about 70 cents). At 25 times leverage, a margin of 1 million yen allows a position of 25 million yen, or about 170,000 dollars (using a 150 yen to the dollar conversion).
3. Intellectually stimulating: Exchange rates tend to follow interest rate differentials, prompting major firms to offer global interest rate tables, economic indicators, central bank updates, and extensive technical analysis tools on their websites and apps. For example, Gaitame.com⁵, which claims to be the first “FX” firm to establish a research think tank, offers 30 currency pairs alongside the aforementioned analyses.

What is the “carry trade” element to “FX”?

The most common definition of a “carry trade” is borrowing in a low-yield currency to invest in a higher-yielding currency. The sharp appreciation of some high-yielding emerging and developed market currency pairs during the week of July 29 can be seen as circumstantial evidence of Mrs. Watanabe’s carry trades being unwound. Notably, all of the largest moves involved the yen. However, obtaining hard data remains challenging.

Specifically, “FX” firms explain the carry trade as going long on the higher-yielding currency and short on the lower-yielding currency. For the USD/JPY pair, this would mean buying the dollar, selling the yen, and earning the policy rate spread in the form of “swap points.” These “swap points” are usually paid daily in yen, making “FX” resemble a fixed-income instrument. For example, the next chart of policy rates for well-known “FX” currencies shows Turkey topping the list, implying a near 50 percent annualized yield from the spread between Turkey and Japan, and a near 10 percent yield for Mexico and Brazil.

Coincidence or not?

Comparing the last two charts, one notices that many of the largest currency moves during the week of July 29 involved currencies from countries with high policy rates, as illustrated on an “FX for Beginners” site⁶. This, combined with comments from “FX” firms, suggests that a carry trade unwind by Mrs. Watanabe may have occurred. Other factors that could explain the yen’s surge include an institutional carry trade unwind and a simple unwind of speculative positions, both of which are reflected in the next graph.

Conclusion

A survey conducted by the Gaitame.com Research Institute in June 2018 found that about 70 percent of “FX” market respondents identified as trend-followers. The yen’s significant post-pandemic weakening could help explain the growth of the market from 2022. Meanwhile, the forced liquidation of positions under “FX” firms’ loss-cutting rules can amplify market moves, as has happened in the past (BOJ, Nov 2018). Comments from “FX” firms and large moves in carry trade pairs suggest that a carry trade unwind by Mrs. Watanabe may have been a contributing factor in the recent yen surge.