Retail investors and some institutional investors focus on the asset they want to acquire in anticipation of price appreciation. The game for some institutional investors is more complicated. It is not only about the asset that is to be purchased, but it is also about how the purchase is funded. A low returning asset is a drag, but if the funding costs can be reduced, a low returning asset may still be attractive.
In the capital markets securing cheap funding is accomplished by selling a low yielding (and ideally a low volatility) instrument and using the proceeds to purchase a higher yielding or a better performing asset. In the foreign exchange market, the dollar is the ultimate funding currency. Americans are the marginal buyer of global equities. They sell dollars and buy foreign equities, and largely on an unhedged basis. Foreign companies and countries borrow dollars and frequently convert the proceeds back to their own currency.
Levered accounts often use the Japanese yen and/or Swiss franc as funding currencies. That is to say, those currencies are borrowed and then sold to buy another asset that is expected generate a higher yield than being paid for the funding. In times of heightened anxiety or a spike in volatility, the trade is unwound, which is to say that the purchased asset is liquidated and the funding is replaced (bought back). That is precisely what appears to have happened last week as the bellicose rhetoric over North Korea escalated. And it was the yen and franc’s weakness before the weekend, which we saw as a tell that the market’s focus was going to shift away from the Korea story.
If the geopolitical anxiety is easing, and the chances that Draghi breaks new ground at Jackson Hole next week, is it a safe time to look at the funding currencies, and if so, which looks better? To be sure when a low yielding instrument is sold for an asset that is expected to offer a higher return, it is often called a carry trade. A carry trade is a trade in which one expected to profit from the interest rate differential. That is the carry.
However, it is often poorly understood. Consider that currently, one can borrow yen for about -3 bp annualized for three months. That yen can then sold, and dollars bought and put in a three-month time deposit and earn about 130 bp annualized for the three months. One earns 133 bp over the three months adjusted for the change in the value of the yen over that period. Over the past three months, the yen has gained 2% (not annualized), which is some multiple of the carry earned.
Moreover, look a bit closer at that carry, 125 bp annualized. That turns out to be about 10.5 bp a month. This year, the dollar has moved on averaged almost 1.3% a month so far this year. On the other hand, the euro rose around 14.5% against from mid-April to early August. The carry earned is overwhelmed by the price appreciation. Some participants may have bought the euro for yen and said it was about the carry, but it was really a momentum trade.
To reiterate, the use of the Swiss franc and Japanese yen as a funding currency is not limited to the currency market, where the volatility, as we have shown, is frequently too great to make a carry strategies practical. The issue is then which currency is a better funding currency now the yen or the Swiss franc.
The Swiss franc offers more negative short-term interest rates and is less volatile than the yen. Specifically, three-month franc LIBOR was fixed at minus 72.5 bp today. Three-month yen LIBOR was fixed at about minus three bp today. Three-month implied volatility is 7.5% annualized for the Swiss franc and 8.7% for the yen. Both countries are experiencing little price pressures. Japan’s July headline CPI was 0.4% year-over-year, while Swiss inflation was 0.3% (0.6% in the EU harmonized methodology). The Swiss economy growth is weaker but less volatile than Japan. Japan’s economy grew 1.0% in Q2 after 0.4% growth in Q1. The Swiss economy grew by 0.3% in Q1. When it reports Q2 GDP in early September, it is expected to have risen by around 0.5%.
On balance, these fundamental considerations suggest that the Swiss franc may be a better funding currency now than the yen. Technical considerations suggest some caution. The franc has depreciated by around 5% against the yen between July 10 and this past Monday. This left the technical indicators a bit stretched. Yesterday’s big advance of the franc over the yen helped lift the RSI, and the Slow Stochastics have already turned up. Minor bullish divergences are evident. The MACDs look poised to cross higher before the weekend.
The cross fell into the lower end of the range seen in the second half of Q2 (~JPY112.50). A move above JPY114.30, last week’s high is needed to confirm a franc low is in place. The JPY114.65-JPY114.75 area houses the 38.2% retracement objective of the last leg down that began on July 25 near JPY118 and the 20-day moving average. The franc has not closed above its 20-day moving average against the yen since July 21.