The appreciation of the yen shakes the funding currency status of carry trades; it remains uncertain whether the Swiss franc, Canadian dollar, or euro will take over.

(1) The yen has long been the primary funding currency for carry trades, but this pattern is changing. As Japan gradually escapes deflation, zero interest rates, and negative real bond yields, the yen reached a seven-month high this week. Market expectations for faster tightening by the Bank of Japan and the possibility that Japanese investors may repatriate capital, along with another round of official intervention in late July, mean the yen is no longer on a one-way depreciation path. Traders now face an imminent question: which currency should replace the yen as the funding currency for carry trades?(2) Each potential candidate comes with its own challenges. The US dollar briefly appeared to be a substitute at the end of February, before the US and Israel struck Iran, but now, with the Federal Reserve and other G10 central banks starting or about to hike rates to deal with inflation, the choice has become difficult. The Swiss franc is the most obvious candidate: the Swiss National Bank’s policy rate has been zero for over a year, the real policy rate is close to -1%, and the 10-year real yield is the only negative one among the G10. JPMorgan calls shorting the Swiss franc “the cleanest choice,” but short positions are already nearing the extreme level seen during the 2024 carry trade frenzy. The Canadian dollar is also being heavily shorted; the Bank of Canada has kept rates at 2.25% for nearly a year, while implied volatility remains very low. However, the US-Canada trade war brings two scenarios: if exports decline and the economy suffers, the Canadian dollar may weaken and become a more attractive funding currency; if the exchange rate weakens and retaliatory tariffs drive up inflation, forcing the central bank to become hawkish, the Canadian dollar's appeal will be greatly diminished.(3) Liquidity is another major obstacle. The yen is the third most traded currency globally, while the trading volume of the Swiss franc and Canadian dollar is only about a third of that. If the trend suddenly reverses, carry traders could face huge losses. The euro offers low volatility, low nominal and real interest rates, and high liquidity. However, the European Central Bank is gradually joining the rate-hiking camp, with markets pricing in a 25 basis point hike on Thursday, and a further 50 basis points by April. Shorting the world’s second largest currency is also risky, though current CFTC speculative positions are roughly neutral.(4) The conclusion is that there may be no clear successor to the yen as the preferred low-yield funding currency. This serves as another reminder to the market: the era of ultra-low rates and relative predictability is over; the investment world has become more uncertain and volatile, and investors need to get used to it.