Citi: A new arbitrage trading opportunity has arrived, with the US dollar taking center stage
Investors have significantly increased their bets on the Fed cutting rates by more than 75 basis points this year. In addition to the Bank of Japan's rate hike in July, analysts believe that this has disrupted the arbitrage trading model that previously relied on Japan's low borrowing costs and borrowing yen to bet on strong US growth. Now, hedge funds are choosing the dollar instead of the yen as the funding currency
Citigroup Group stated that arbitrage trading has now returned, but the main character has changed: hedge funds are now borrowing US dollars instead of Japanese yen to bet on emerging markets.
According to media reports, investors have significantly increased their bets on the Federal Reserve cutting interest rates by more than 75 basis points this year. Combined with the Bank of Japan's rate hike in July, analysts believe that this has disrupted the arbitrage trading model that previously used low Japanese borrowing costs to borrow yen and bet on strong US growth.
Kristjan Kasikov, head of global forex quantitative investment solutions at Citigroup Group, said:
"We are seeing a more bearish sentiment towards the US dollar, and the market's expectation of rate cuts has fueled this risk appetite."
Analysts believe that the global economic downturn at the beginning of this month dealt a heavy blow to arbitrage trading, and the current situation marks a shift in the arbitrage trading model.
In arbitrage trading, investors borrow low-interest currencies and park the funds in high-interest risk assets. In recent years, due to the Bank of Japan's zero interest rate policy, the yen has been the most popular funding currency, and this strategy has been a regular operation for the Japanese government and financial institutions over the past forty years.
Kasikov stated that given the potential interest rate differentiation between the US and Japan, hedge funds using this strategy now choose the US dollar as the funding currency instead of the yen.
The US dollar has been at its lowest point since March, and since August 5th, hedge funds have been using the dollar to buy emerging market currencies, including the Brazilian real and the Turkish lira.
In the first half of 2024, as traders reduced expectations of aggressive rate cuts by the Federal Reserve, the US dollar steadily climbed. The dollar index compiled by the media rose by nearly 5% from January to June, while the yen fell to its lowest level in nearly 40 years.
However, the Bank of Japan's rate hike led to a sharp reversal in the situation in August, resulting in a large volume of trades among hedge funds. Generally, hedge funds are usually able to enter and exit trades faster than large asset management companies.
According to data compiled by the Commodity Futures Trading Commission (CFTC) since 2021, hedge funds that have been bearish on the yen in the futures and options markets have started to take a positive stance on the yen due to the historic shift in interest rate policy signaled by the Bank of Japan's rate hike.
"Citigroup's hedge fund clients were unusually active in forex trading in August this year, with recent trading volumes at the high end of historical ranges," Kasikov said. On the other hand, trading volumes for asset management clients were lower than usual.
However, Citigroup expects that the window of opportunity for global arbitrage trading to perform well may be short, as the turmoil surrounding the US presidential election could lead to another surge in market volatility, Kasikov said.
"We have been concerned about forex arbitrage trading for some time," he said. "The US election and political agenda will bring more volatility and risk aversion sentiment to the market, which will have a negative impact."