Global 75% Arbitrage Trades Closed

Despite significant hedge fund exits from carry trades, yen volatility may not yet be dead...

Hedge funds appear to have pulled back from their bullish bets on the yen, but are still paying high hedging prices at current levels, indicating increased market uncertainty about the future trajectory of the yen.

According to Ruchir Sharma, head of global foreign exchange options trading at Nomura International in London, dovish remarks by Bank of Japan Deputy Governor Shinichi Uchida on Wednesday reduced the relative cost of yen appreciation hedging for the next month by about a third. However, he noted that despite the yen itself falling, the hedging prices in the forward market remain high.

Uchida pledged to avoid rate hikes during market instability, sending a strong signal following historic financial market volatility in Japan. This volatility was partly triggered by the recent sharp rise in the yen.

"The premium the market is willing to pay for yen call options compared to yen put options has fallen significantly," said Sharma. "Fast money has been actively involved in the past 48 hours, but a lot of funds are still on the sidelines, waiting for the market to stabilize before getting involved."

The yen has been volatile this week, rising sharply at the beginning of the week as leveraged funds continued to close their short yen positions, but quickly fell back after Uchida's speech. The US dollar to yen exchange rate even broke below 142 on Monday and approached 148 on Wednesday.

JPMorgan said that three-quarters of global carry trades have been closed, with the recent decline erasing this year's gains. Quantitative strategists Antonin Delair, Meera Chandan, and Kunj Padh wrote in a letter to clients that the returns of the G-10, emerging market, and global carry trade baskets they track have fallen about 10% since May. The decline has erased year-to-date returns and significantly reduced profits accumulated since the end of 2022.

The team wrote that the spot part of the global carry trade basket indicates that 75% of carry trades have been closed. They reiterated that there is not much time left for G-10 carry trades. The strategists said that the opportunity for a rebound in August may be slim, with the central bank's schedule relatively light during this period and volatility already cooling down.

However, for now, the indicator measuring the expected volatility of the US dollar against the yen for the next month is still close to the highest level since January 2023. Some analysts say there is reason to believe that the US-Japan exchange rate may be capped at 148.00 in the future, with the Bank of Japan being more hawkish than imagined, the narrowing of Japan-US interest rate differentials, and Japanese exporters and investors selling foreign exchange, all of which will continue to push the yen higher.

The summary of opinions from the Bank of Japan's July meeting released earlier showed that the policy board is more hawkish than imagined and will continue to be hawkish as suggested by Governor Haruhiko Kuroda, and may even raise interest rates again before the end of this year, despite the dovish remarks made by Deputy Governor Shinichi Uchida on Wednesday. There is no doubt that the market will eventually stabilize, which will allow Bank of Japan policymakers to be less reserved about raising interest rates again due to concerns about disturbing the market.