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Japan's descent into a negative interest rate policy should have weakened the yen, but instead it's spurring a rally as appetite for using the currency to fund other bets wanes.
The yen strengthened on Thursday to highs not seen since October of 2014, with the dollar fetching as few as 110.98 yen. That's despite the Bank of Japan (BOJ) blindsiding global financial markets on January 29 by adopting negative interest rates for the first time ever - a move that should spur outflows of the local currency, not inflows.
Instead, a confluence of factors - worries about banks' profits, a commodities price slump and uncertainty over the Federal Reserve's hiking path - is causing an old favorite, the yen carry trade, to fall out of fashion, which means the currency is moving in the opposite direction to that expected in the wake of the BOJ's surprise rates move.
"The advent of negative rates is compounding concerns about underlying strains in the financial sector and bank profitability," Ray Attrill, co-head of foreign-exchange strategy at National Australia Bank, told CNBC's "Street Signs" on Wednesday.
Japanese investors are repatriating funds in part because the BOJ's move sparked concerns that other central banks could wage a campaign of competitive rate cuts in response. This in turn caused worries about global banks' earnings because negative interest rates in Japan - as well as low interest rates globally - dents the banks' net interest margins. That's a driver of why bank shares have sold off particularly viciously in recent weeks amid a wider global market rout.
"In risk-off environments, capital tends to come home, but I think that's being compounded by some of these strains in the financial sector that's causing a lot of capital repatriation," Attrill explained
In Asian morning trade on Friday, the dollar bought as few as 111.91 yen, and Reuters reported that Japan's Finance Minister Taro Aso said recent yen moves had been rough and that such sudden moves were undesirable. Aso reportedly added that policymakers would take appropriate steps if necessary. He declined to comment on whether Japan had or would step into the market as traders speculated that the yen's sharp overnight move lower might have been due to intervention.
But even if market sentiment calmed, the yen-funded carry trade may not make much of a comeback.
The yen is traditionally seen as a low-yielding currency because Japan historically had the lowest interest rates among developed countries and policymakers were generally seen as motivated to maintain policies that would help weaken the yen.
A carry trade is when investors borrow in a low-yielding currency, such as the yen or the euro, to fund investments in higher-yielding assets elsewhere. 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.
The yen carry trade has a storied history. Yen-funded bets on Australia had grown so large in the lead-up to the global financial crisis that when the crisis hit in 2007, the sheer volume of flows out of the Australian dollar and back into the yen pushed the Aussie down almost 50 percent to a post-World War II low of 55 yen, forcing the the Reserve Bank of Australia to intervene to support its currency.
On Friday, the Australian dollar was fetching 79.90 yen.
"Since the last financial crisis, though, short-term interest rates have been close to zero in much of the developed world," John Higgins, an economist at Capital Economics, said in a note Thursday. "As a result, not only has the relative appeal of the yen as a funding currency declined, but the absolute appeal of carry trades in general has also waned."
He noted that the BOJ's data on the interoffice assets of foreign banks operating in Japan shows there wasn't too much interest in the carry trade.
"When in the past these branches have borrowed yen in the interbank market and lent it on to their head offices abroad, the purpose has often been for the head office to implement a yen carry trade," he said.
While those trades increased sharply through 2007 before plummeting amid the financial crisis, they've only increased a bit since then, to around 30 percent of the peak at the end of 2015, Higgins said.
That may be in part because if there isn't much of an interest rate differential, the carry trade would add an extra layer of foreign-exchange risk to borrowing for riskier investments.
Another factor making the yen carry trade less attractive: The crash in commodity prices means traditional investment destination Australia was no longer quite as interesting an investment opportunity, especially as the Reserve Bank of Australia has already set interest rates at a record low 2 percent, with wide expectations for further cuts ahead.
Another potential destination for carry trades - into the U.S. dollar - has also been frustrated by recent market moves.
Although the greenback had widely been expected to continue to strengthen as the U.S. Federal Reserve became the sole major central bank embarking on a tightening cycle, the dollar is instead losing ground against a basket of currencies. Markets aren't pricing in any Fed interest rate increases this year and policymakers appear to be stepping back from their stated goal of increasing interest rates as many as four times this year.
"You need to be able to expect a stable spread," said Takuji Okubo, managing director and chief economist at Japan Macro Advisors Monday. "Now you don't really know where the dollar is going."
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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter