Yen faces sustained slide from carry trade revival

A revival in yen carry trade is set to place the Japanese currency on a sustained slide as the Bank of Japan keeps printing money at a time when central banks in the eurozone and the United States move closer to lifting interest rates.
The BOJ is becoming the last of major central banks to unwind its super-loose policy, keeping yen interest rates near zero and lagging the rise in rates elsewhere.
This rekindles the yen's use as a funding vehicle, a role the currency played from 2005 until the 2008 financial crisis when the carry trade - selling low interest-rate currencies to fund high-yielding investments - collapsed. Co-ordinated FX intervention on March 18 by major central banks has shown that authorities are determined to act to stem a rapid yen rise, making investors nervous about pushing the currency higher.
Higher US yields will make the dollar less attractive as a funding currency and are likely to prompt Japanese institutional investors to unwind currency hedges on their hefty overseas bond holdings, a shift that should give the dollar a boost.
Moreover, import needs for energy and resources to rebuild north-eastern Japan devastated by the March 11 earthquake may lead to yen selling pressure and even trade deficits for Japan.
"The current risk environment is preventing the dollar/yen from tracking interest rate differentials, but the relationship could strengthen again in the medium term and upward pressure on the yen is likely to recede," said Masafumi Yamamoto, chief currency strategist at Barclays Capital.
Investors also scaling back expectations that Japanese investors would repatriate their overseas funds en masse after the quake - a factor that drove the dollar to a three-week high of 83.16 yen on Wednesday, up 9 percent since its record low of 76.25 set on March 17.
The dollar faces heavy chart resistance in the near-term, but a move above 85.94 yen - the high reached during Japan's one-day bout of solo intervention last September - would put it on a path towards a sustained rise.
The higher-yielding Australian dollar has risen more than 14 percent from pre-intervention lows, a move that reinforces the yen's regaining its funding status.
One key sign that interest-rate differentials are playing a greater role and should help drive the dollar higher: the correlation between US-Japan interest rate spreads and dollar/yen is re-establishing its traditional strength.
Hawkish comments from Federal Reserve officials this week are raising expectations the Fed would kick off its tightening cycle as early as later this year. The two-year Treasury yield has hit a 3-week high at 0.825 percent. In contrast, comparable Japanese yields have dipped to 0.205 percent as banks park funds in short-term paper after the BOJ's post-quake fund injections.
As a result, the US-Japan two-year spread has reached 62 basis points, compared with around 33 bps on March 16 and a record low of 20 bps reached last year.
The yen and US-Japan yield spread have historically enjoyed close relationship, suggesting wider yield spreads will help push dollar/yen higher.