As confidence returns to global markets, investors appear to be using the cheap yen once again to fund investments in risky assets – a trade that is likely to give the battered Japanese currency another boot lower in the months ahead, analysts said.
The yen has lost 13 percent of its value against the U.S. dollar in the past three months, hitting a 2-1/2 year low on Monday on expectations of aggressive monetary policy from Japan, which under a new government is set on ending years of deflation and pushing its economy out of recession.
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This backdrop coincides with a sentiment shift in financial markets, with investors increasingly moving into more risky assets.
"The yen is regaining its ground as a funding currency," said Jesper Bargmann, head of G11 currencies at Royal Bank of Scotland in Singapore. "Sentiment has changed in markets, pretty much since January 1. Risk appetite has returned, there's increased confidence and a search for yield, so the yen seems to be suffering as a result of that," he said.
"Of course the political climate is important because the backdrop of (Japanese Prime Minister Shinzo) Abe pushing for an aggressive monetary policy started the weakening in the yen," Bargmann added.
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A carry trade is when investors borrow in a low yielding currency, such as the yen, to fund investments in higher yielding assets somewhere else.
The so-called yen carry trade was last in fashion in 2004-2008 and during this period the yen weakened about 20 percent against the dollar. That was before the global financial crisis hit, sapping demand for risk assets and sending investors scurrying into safe-haven assets.
In recent years, the trade has been less popular as monetary easing in the U.S. and Europe kept interest rates for banks artificially low, increasing the appeal of using the dollar and the euro instead of the yen.
A weakening currency is central to the carry trade since it means that investors have less to repay when they cash out of the trade.
"There's actually been a covering of short positions in the yen recently, yet the yen continues to weaken," said Credit Agricole's Head of Global Currency Research Mitul Kotecha. "So, this suggests that other classes of investors are selling the yen and I think this is because the yen is increasingly being used as a funding currency."
Bargmann at RBS says he expects the dollar/yen rate to reach 100 in the second-half of the year from current levels around 90.
"We are seeing the carry trade, but it is more selective than what we saw in 2004-2007, when money went into all risk assets," he said. "The reason for this is because fear in financial markets has been replaced by caution following the global financial crisis."
Risk On, Yen Down
Analysts say they are increasingly viewing the yen's decline in the context of growing risk appetite and falling demand for safe-haven currencies which include the yen, Sterling and the Swiss franc.
"The yen is very closely correlated with our risk barometer, so as risk appetite improves, dollar/yen moves higher," said Kotecha at Credit Agricole.
The pound has tumbled about 3.5 percent against the dollar this month, while the yen has weakened 4.5 percent versus the greenback and the Swiss franc has tumbled 3 percent against the euro.
In contrast, riskier assets have seen some solid gains: The S&P 500 on Friday logged its longest winning streak since 2004, while stock markets in Europe have rallied 3.5 percent so far this month and shares in Asia are up about 2 percent.
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"Not only is the yen losing ground because of Abe's comments and monetary policy. But also, we're seeing risk appetite improving across the globe and so the yen is weakening because it was a safe-haven currency and now it's being sold because people are buying risk again," David Harden, senior commercial dealer at Global Reach Partners told CNBC Europe's "Squawk Box" on Monday.
"Look at Sterling, the Swiss franc and Japanese yen, they've all depreciated. In fact they're the worst G10 currencies so far this year. While the market is buying risk, investors are selling safe-haven currencies, so that's the yen, the Swiss franc and the pound," he added, saying he anticipated further yen depreciation.
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For the yen carry trade to pick-up further, there needed to be more signs of a rebound in the global economy, analysts said.
"What we need to see is the monetary easing globally spill over into the real economy and then we'll see the carry trades pick up some more. There are some risks but in all the carry trade is likely to continue," said Bargmann at RBS.
- By CNBC's Dhara Ranasinghe; Follow her on Twitter: @DharaCNBC