(May 28): Rising interest rates in Japan will do little to rescue the beleaguered yen, as long as there’s demand for one of the most lucrative bets in foreign exchange, traders say.

The yen remains one of the hottest macro assets to sell, as part of so-called carry trades — a strategy that involves borrowing Japan’s currency for almost nothing, to buy dollars and earn more than 5%. The weakening yen and strengthening greenback are increasing the attractiveness of the carry trade, by boosting its total return over the last year to 18%.

That’s setting up a potentially tense showdown with Japanese authorities who appear bent on stymieing the yen’s seemingly excessive weakness. The central bank’s next policy meeting may be just over two weeks away, but some market participants are already warning that the yen is at risk of falling back to around a 34-year low of 160.17, as long as these carry strategies remain in vogue.

“People are obsessed with carry,” said Antony Foster, London-based head of Group-of-10 spot trading at Nomura International Plc. “Even if the Bank of Japan (BOJ) does raise rates in June — we are forecasting a tiny raise and then more later in the year — this carry will still exist and therefore, the market will be very reluctant to be long yen.”

The Japanese currency has dropped about 10% against the dollar this year, the biggest loser among Group-of-10 peers, as investors abandoned the yen for higher-yielding alternatives. Angst among Japanese officials has been mounting, as the yen trades near half the value it was in 2012, triggering repeated threats of intervention to prop up the currency. They are suspected to have actually stepped into the currency market in late April and early May.

While the yen has retreated to around the 157 per dollar mark, further attacks may be on their way. Swap markets have already priced in a further 27 basis points of BOJ rate hikes this year, with a 90% probability of increase of 10 basis points as soon as July. However, with traders already having factored in the rate increases, any hawkish signals from Japan’s central bank next month may prove insufficient to stop the yen’s slide lower.

“Anything from BOJ will likely be too little too late, with market momentum and carry trade demand favour[ing] shorting yen,” said Mingze Wu, a Singapore-based currency trader at Stonex Financial Pte Ltd. “Risks for dollar-yen lean towards upside back towards pre-BOJ intervention levels.”

Intervention risks

Given that the weakening yen is boosting the carry trade’s return, investors will be watching to see if the BOJ, led by governor Kazuo Ueda, will try to stem its slide next month. Markets are only assigning a 28% probability to a 10 basis point rate increase, so carry traders will be on the lookout to see if the central bank tweaks other policy tools to try and support the currency.

“Ueda is likely to choose his words very carefully to avoid sounding dovish, compared with market expectations,” says Jane Foley, London-based head of FX strategy at Rabobank. “He and the MOF (Ministry of Finance) will likely be hoping that no more intervention will be needed, but this cannot be guaranteed, as long as Japanese economic data are soft and if US data signal resilience.”