Japan inflation shock could fuel carry unwind

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) - Rising U.S. bond yields have yet to tarnish the allure of carry trades, but an inflation shock in either Japan or Switzerland that would prompt more aggressive rate rises could force investors to unravel these foreign exchange-linked deals, currency strategists said this week.

A benchmark interest rate increase by Japan or Switzerland would reduce the United States' wide rate spread with these countries and consequently lower the risk-adjusted return of holding bearish yen or Swiss franc bets in carry trades.

In these transactions, investors borrow in low-yielding currencies and invest in assets with higher returns to take advantage of the rate differential.

Last week's surge in global yields fueled concerns carry trades could unwind and result in more volatility in financial markets. The surge in yields reflected expectations for persistent inflation and tighter monetary policy by central banks around the world.

A massive carry sell-off did not happen as stocks recovered and bond yields stabilized. But analysts warned of risk factors that could turn the tide against carry trades.

"One risk factor (for carry trades to unwind) would be if we saw a significant spike in yields in Japan or any of the funding currencies," said Mike Moran, senior currency strategist at Standard Chartered Bank, at a Reuters Investment Summit in New York this week.

"That would infer we would have some kind of inflation shock in Japan or Switzerland," he added.

At the moment, though, inflation remains tame in both countries, although price pressures in their economies have picked up.

In Japan, the pace of the decline in consumer prices has slowed, suggesting inflation is slowly returning.

Japanese government bond yields, meanwhile, have soared in recent sessions, tracking other bond markets, reflecting rising expectations the Bank of Japan could raise interest rates in a few months after the most recent crop of positive economic data.

Moran pointed out that if the spread between two-year Japanese and U.S. bond yields narrowed to between 200-250 basis points, that could hurt carry trades. At the moment, though, the differential between the U.S. and Japanese two-year bond yields is about 470 basis points, according to Reuters data.

Analysts expect the BoJ to hike rates to a 12-year high of 0.75 percent, from the current 0.5 percent, in August or September following parliamentary elections in July. BoJ Governor Toshihiko Fukui has said the central bank could raise rates even if inflation is still in negative territory as long as the long-term outlook for prices to rise remains in place.

In Switzerland, meanwhile, inflation was steady in May but higher than the previous month. That backed a move by the Swiss National Bank earlier on Thursday to raise interest rates to 2.75 percent. The SNB also signaled that more hikes are likely, especially if the economy remains strong and the Swiss franc weakens.

Strategists also said a Federal Reserve rate hike could unravel carry trades, especially amid robust U.S. data.

"The broader inflation trend is key. If markets start to price in a Fed tightening then that could pretty much unwind some of the carry positions," said Brian Garvey, senior currency strategist at State Street Bank. He added that benchmark U.S. yields at 5.50 percent to 6.5 percent could change sentiment on these transactions.  Continued...