Over the past two and a half years the carry trade has produced the easiest profits in the currency market. Since the start of 2005 USD/JPY has risen from 101.67 to a high of 124.13 gaining 22% while GBP/JPY has catapulted from 195.05 to 248.77 a rise of 27.5% and the quintessential carry trade pair – AUDJ/JPY - has performed best of all registering gains of 38% as it shot up from 76.95 to 106.28. These gains merely reflect capital appreciation on the position and do not even take into account the massive interest payment flows that accrued over the past few years. As an example, an investor holding long GBPJPY position since the start of 2005 on a modest 3 to 1 leverage factor would have earned approximately $30,000 of interest on $70,000 of equity in addition to the aforementioned gains..

Little wonder then that the carry trade has become so popular amongst retail traders worldwide. Indeed the biggest practitioners of the carry trade have been the Japanese themselves. Faced with paltry 0.5% yields on their savings accounts, Japanese retail customers have been voracious hunters of yield, parking their capital in such high yielding currencies like the New Zealand dollar (8.00%), the Aussie (6.25%) and the pound (5.75%). In a recent article on Bloomberg entitled, “Housewives Outmaneuver UBS, Deutsche Bank Trading Yen” the reporter noted that retail traders have tripled their trading volume in this trade to $11 Billion per day. ``They are the bane of professional currency traders,'' noted Masanobu Ishikawa, general manager of foreign exchange at Tokyo Forex & Ueda Harlow Ltd., who has been trading in Japan's capital city for 25 years. ``It's becoming hard to make money as the dollar-yen doesn't move as it used to, because of their constant buying on dips.'' Demand for the carry trade has been so strong that Japanese broker dealers are issuing massive 1.1 Trillion yen currency trusts designed to further capitalize on this strategy.

Sentiment Favors a Pause

On the eve of the BOJ decision however, with most carry trades still hovering near record highs, is there still any upside left in this strategy? Looking at current sentiment readings one could certainly have cause for concern as the latest COT data shows near record levels of bearishness on the yen suggesting that the speculative positioning may be too skewed against the currency. Furthermore, as we noted several days ago, when we referred to the news on the currency trust issuance “These types of moves are far more emblematic of a top rather than a bottom (in USD/JPY) as retail demand is almost universally wrong, peaking just before a turn.“

Still sentiment data alone rarely serves as an accurate signal of price exhaustion. At very best it suggests that the rally in the carry trade may be due for a pause. In order for carry trade to be truly over, the market will need to see key changes in Japanese policy which have yet to take place.

Risk Aversion – Yen’s Only Friend

Over the past several years yen’s only periods of strength occurred during bouts of risk aversion such as the one that took place in March of this year, after global equity markets sold off on jitters over the sharp declines in Shanghai index. Yesterday’s announcement by Moody’s about the re-rating of $12 Billion of sub-prime debt was yet another example of this dynamic in action as USD/JPY fell nearly 200 points in less than 24 hours. Typically these sell-offs have been quite sharp but very brief, as risk appetite quickly returned and volatility compressed, once again creating favorable conditions for the carry trade. In short, while risk aversion may have dented the carry trade, it has not seriously damaged it, with every dip proving to be a buy on the way to new highs in yen based crosses. Unless global equities suddenly enter into a bear market, risk aversion is unlikely to serve as the primary cause of the end of the carry trade.

Sustained Change in Monetary Policy

Only Japanese monetary policy can change the relentless one way price action against the yen. Although the BOJ has long ago moved away from ZIRP (Zero Interest rate Policy) the tightening process has been painfully slow with Japanese monetary authorities raising rates only twice over the past 12 months. Indeed, the tightening has crawled at such a snail’s pace that the long end of the Japanese yield curve has hardly budged providing ample liquidity for additional carry trades. As we move forward, the key metric for currency traders to watch will be the 2.00% rate on the 10 year Japanese Government Bonds. Should yields rise and hold that level, many Japanese insurance companies and pension plans will repatriate their capital from abroad providing a strong boost for the yen.

However, such an increase in JGB yields is unlikely unless BOJ changes its monetary stance. Up to now, Japanese central bankers have been extremely reluctant to act aggressively for fear of tipping the country back into a recession. Having survived a decade long bout with crippling deflation, Japanese policy makers remain scarred by the experience and have therefore been extraordinarily cautious in their policy choices. Meanwhile, Japanese economic data has not made a case for strong tightening with consumer demand still lackluster. In fact the latest Eco- Watchers survey actually showed a marked decline in sentiment dropping to 46, well below the 50 boom/bust level.

Nevertheless, despite the less that stellar fundamentals, consensus is building in Japan that the yen may have declined too far too fast. One reason for this view has been the rapidly rising cost of oil which at $72/bbl is becoming extraordinarily expensive for the Japanese business’s to acquire. Furthermore, the persistent debasing of the currency has greatly hurt the purchasing power of the Japanese consumer. In 1998 Japan enjoyed the highest purchasing power in per capita terms, but today the country have slipped to 15th in eth world, largely as a result of yen devaluation. In short, the costs of a persistently low yen may be outweighing its benefits in Japan for both businesses and consumers..

Yet change in policy takes a long time. That is why this week’s BOJ post announcement statement may be critical to determining the future direction of the currency. Up to now Japanese policy makers have consistently communicated the message of “gradual” normalization of rates. In practice this has actually meant a neutral policy as monetary authorities patiently awaited a pick up in consumer demand. However, with Japanese unemployment rate now at near decade lows, serving as strong evidence of the robustness of the labor market, the BOJ may be emboldened to act more aggressively.

The key focus will be on the change of tone from Governor Fukui. If BOJ Chief simply hints that the central bank will embark on a sustained path of rate increases, that news alone may be enough to curtail any further gains in the carry trade. While the spread between the yen and the high yielders will remain wide for the foreseeable future even if the BOJ begins to implement rate hikes on a regular basis, it is the narrowing of that spread that will be of prime importance to the currency markets which are always discounting the future. Thus, if the BOJ provides even the slightest clue to a shift in policy, the easy profits in the carry trade may be over. However, if tomorrow simply confirms the status quo of the past 12 months, the dip buying Japanese retail traders may be proven right once again.

Boris Schlossberg is a Senior Currency Strategist at FXCM.