Carry trade: after the yen, is it now the franc’s turn?
Keystone-SDA
The carry trade phenomenon, one of the most widespread strategies on the foreign exchange markets, has recently been drawing even more attention to the Swiss franc.
Historically dominated by the Japanese yen as the funding currency, this type of transaction may now also be more attractive using the Swiss franc, thanks to the Swiss National Bank’s (SNB) key interest rate remaining at 0%, whilst rates are rising elsewhere.
The mechanism behind the carry trade is simple: an investor borrows in a low-cost currency (such as the yen) and invests the proceeds in a currency or asset offering higher returns, such as the US dollar.
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The difference between the cost of borrowing and the return on the investment constitutes the profit, known as the ‘carry’. The main risk lies in the exchange rate: if the currency used to borrow strengthens, the interest income may be offset or exceeded by the exchange rate loss.
For years, the yen has been the funding currency par excellence, thanks to Japan’s ultra-accommodative monetary policy. However, recent moves by the Bank of Japan – which has raised interest rates and, for the first time in 30 years, intervened alongside the United States to prop up the currency – have put highly leveraged carry trade positions under pressure.
A strengthening of the yen, in fact, makes it more expensive to repay loans and can trigger forced selling.
This is where the franc comes into play. With a key interest rate of 0% and an internationally significant swap market (derivative contracts), the franc could become an attractive funding currency, especially if Japanese rates were to rise further.
But the more investors choose the franc for financing, the more they are implicitly betting that it will not strengthen.
In the event of geopolitical crises or a resurgence in demand for safe-haven assets, however, many would be forced to sell their foreign assets and buy back francs, fuelling the very appreciation they were seeking to avoid.
The recent history of the yen shows that carry trades can become a systemic risk when too many market participants try to exit at the same time.
The franc now faces this scenario. On the one hand as a possible new funding currency, and on the other as a potential victim of its own success.
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Translated from Italian, reviewed by an English Department journalist.
