By Alun John and Tom Westbrook

LONDON/SINGAPORE (Reuters) – The Bank of Japan’s decision to raise interest rates to a 15-year high sent the yen higher against the dollar since March and set it up for further gains as investors reassess carry trades that have become a preferred option this year.

The change will come as a relief to Japan’s Finance Ministry, which has spent 5.53 trillion yen ($37 billion) in the foreign exchange market this month to support its currency, data showed on Wednesday. It is the second round of interventions this year.

Wednesday’s rate hike was the biggest since 2007 and came just months after the BOJ ended eight years of negative interest rates. Governor Kazuo Ueda also did not rule out another hike this year and stressed the bank’s willingness to continue raising borrowing costs to levels seen as neutral for the economy.

The dollar weakened 1.7% against the Japanese currency to 150.2 yen after the Bank of Japan’s decision and is now more than 10 yen lower than its early July level of 161.9.

The July level was the weakest since 1986. The yen has come under severe pressure as favourable market conditions and a wide spread between borrowing costs in Japan and elsewhere have made it a popular choice as a financial currency in carry trades.

In this case, investors borrow money in a currency where interest rates are low (the yen is a popular one) and then exchange it for another currency in which they can invest in higher-yielding assets.

They were popular with investors earlier this year when expected global interest rate cuts in early 2024 were postponed and currency prices were stable – sudden price swings can wipe out yield gains.

But as the BOJ raises rates at a time when rate cuts by central banks around the world are finally gaining momentum, investors are changing tack.

“It’s the pace of change (in interest rate differentials) that matters. So if the BOJ accelerates the pace of rate hikes relative to market prices, and the Fed starts to act here as well, carry pressure increases,” said James Malcolm, head of currency strategy at UBS.

The Federal Reserve kept interest rates unchanged on Wednesday but said it would cut borrowing costs at its next meeting in September as inflation continues to approach the U.S. central bank’s 2% target.

“Hedge funds are likely reassessing their strategies in light of these events,” said Tareck Horchani, head of prime broker trading at Maybank Securities in Singapore.

“This change could reduce the attractiveness of short yen positions as the narrowing interest rate differential between the BOJ and other central banks, particularly the Fed, which is likely to cut rates in September and December, makes the yen less attractive for carry trades.”

PACE AND VARIATION

While it is complex to estimate the exact size of global yen-financed carry trade positions, and therefore the impact their unwinding could have on the currency, many speculative positions are based on pure currency swaps between the yen and higher-yielding currencies.

There are also short-term investments financed in yen worth hundreds of billions of dollars.

For example, yen-funded carry trades in U.S. Treasuries are yielding nearly 6% — a powerful incentive for market participants that Japan has struggled to counter so far. The BOJ’s 15 basis point rate hike will only slightly weaken the carry trades.

However, one factor that can disrupt trades and force liquidations is volatility.

“The carry trade works well when volatility is low, but if volatility increases, people will unwind positions,” said Yusuke Miyairi, currency strategist at Nomura.

That trend is growing, with implied overnight volatility in the dollar versus the yen rising to 27% on Wednesday, the highest level this year.

It wasn’t just the BOJ’s move on Wednesday that shook the yen, as MOF intervention in early July halted the currency’s decline. Republican presidential candidate Donald Trump’s comments criticizing Japan for the yen’s weakness and the Fed’s changing expectations were also in the mix.

These factors have already triggered a pullback in carry trade activity, affecting currencies from Mexico to Switzerland.

CFTC data shows speculative bets on a yen decline are 40% below April’s high of $8.61 billion.

And there is still room for more dramatic changes in the yen’s exchange rate.

“You can’t rule out that there could be a five-, seven- or even a historic high of 10 (yen) in a single day,” UBS’s Malcolm said.

“In 1998, we had two consecutive days of 10 (yen) dollar/yen moves. That’s what carry trades look like. That’s what we’ve seen in the past, and that’s what we’ve seen today.”