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The authors would like to thank Anh Van Le for her excellent research assistance and are grateful to Paul Cashin, Todd Schneider, Aki Yokoyama (all IMF), Yoshihito Saito (IMF Alternate Executive Director), Kentaro Ogata, Koji Uemura (both Ministry of Finance, Japan), and seminar participants at the Japanese Ministry of Finance for their valuable comments and suggestions. All errors are our own.
The negative/positive effect of a yen appreciation/depreciation on corporate profits and equity prices is frequently referenced in the Bank of Japan’s quarterly publication on the economic outlook (e.g., BoJ, 2014, and 2016a). In addition, a yen appreciation may affect the profitability of financial institutions as it reduces profits from revenues denominated in foreign currencies (e.g., BoJ, 2016b)
Safe haven appreciations typically occur during heightened market uncertainty/risk-off periods when investors move into assets that are perceived as “safe”—such as Japanese government bonds (JGBs).
This implicitly assumes that the uncovered interest rate parity does not hold, which tends to be true empirically (see Fama, 1984).
Following Brunnermeier and others (2008), the net futures position of non-commercial traders is used as a proxy measure for carry trade activity. The net futures positions are calculated by subtracting non-commercial traders’ short futures position in yen from their long futures position in yen, both expressed as a fraction of total open interest of all traders. Non-commercial traders are classified as those who do not use futures for hedging purposes by the U.S. Commodity Futures Trading Commission (CFTC). Although this measure only captures the derivatives carry trade activities through futures but not those through forward contracts, it should be a valid indicator for the overall carry trade as the non-commercial traders are basically speculators who use futures to engage in carry trade (Brunnermeier and others, 2008). Daily observations are used for the two-year U.S.-Japan interest rate differential, VIX and exchange rate, while only weekly data is available for the net yen non-commercial position.
The impact of carry trade reversal on exchange rate movement becomes statistically insignificant only when it is ranked last in the Cholesky ordering, while the effects of other shocks remain qualitatively unchanged. Moreover, the main qualitative results also hold when we include the EPFR fund flow data—a proxy measure of capital flows at weekly frequency.
The impulse responses to a shock to the 10-year interest rate differential are suppressed from Figure 2 as they are qualitatively similar to those to a shock to the 2-year interest rate differential albeit with less statistical significance.
Notice that the impulse responses of exchange rate movement presented in Figure 2 are average daily percent changes.
The narrowing in the interest rate differential between the U.S. and Japan could happen when U.S. interest rates decline while interest rates in Japan remain constant under its Yield Curve Control (YCC) policy.
The pure speculative shock to carry trade activities is orthogonal to the shocks to VIX and interest rate differentials in the baseline VAR model (1).