## wpiea2019136

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**Canonical URL:** [wpiea2019136](https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019136.pdf)

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---

### I. Introduction — scope and main conclusions
- Paper examines drivers of rapid yen appreciations, emphasizing amplifying roles of carry-trade activity and the zero lower bound (ZLB).
- Three main conclusions:
  - A rise in foreign interest rates tends to depreciate the yen but encourages carry trade (net short yen positions), increasing the likelihood of large yen appreciations when carry trades reverse.
  - Heightened uncertainty typically leads to yen appreciation via safe-haven effects, amplified by carry trade reversals; because Japanese interest rates are constrained by the ZLB, yen appreciation is likely to be more pronounced than that of other safe-haven currencies.
  - Carry trade reversals act as shock amplifiers; purely speculative shocks can trigger self-fulfilling appreciation cycles as yen appreciation prompts further carry trade reversals.

### II. Main drivers of short-run yen dynamics
- Monetary policy shifts
  - Exchange rates reflect expected future interest rate differentials between foreign and domestic short-term rates.
  - A sharp fall in current or expected U.S. short-term rates should immediately appreciate the yen vs. the U.S. dollar.
- Safe-haven effects
  - During risk-off episodes, investors move into perceived safe currencies (U.S. dollar, yen, Swiss franc); a rise in market uncertainty tends to appreciate the yen.
- Carry trade reversals
  - Carry trade: borrow in a low-interest funding currency (yen) and invest in a high-interest target currency; profitable only if exchange rate moves do not eliminate carry.
  - Leveraged, unhedged positions mean funding-currency appreciation (or fear of it) can cause sharp unwinding and reinforce appreciation.
  - Japan’s near-zero interest rates for about two decades have made the yen a popular funding currency and particularly vulnerable to carry trade reversals.

### III. Three episodes of large and rapid yen appreciations (event study)
- Methodology and variables
  - Episodes identified via threshold methodology on appreciation size and sequencing of three drivers using quantitative and narrative records.
  - Variables: change in two-year U.S.-Japan interest rate differential, VIX gap relative to its 60-day average, net non-commercial yen futures position.
  - Data frequency: daily for two-year differential, VIX, and exchange rate; weekly for net yen non-commercial position.
- Episode 1 (April–June 2006): Risk aversion and carry trade reversal
  - During 2005, U.S.-Japan two-year differential rose by around 100 basis points causing yen depreciation and expansion of carry trade positions.
  - Early 2006 unwind of carry trades led to a sharp yen appreciation of more than 5 percent in April–May, 2006.
  - VIX did not rise above its 60-day average until mid-May; two-year differential did not move significantly.
  - Carry trade reversal alone explains over 40 percent of the peak cumulative appreciation of the yen (historical decomposition).
- Episode 2 (October–November 2007): Financial stability concerns and U.S. monetary easing
  - September 2007: Fed cut federal funds rate by 50 basis points.
  - Two-year U.S.-Japan differential started to fall in mid-October and by end-November it had fallen by 100 basis points; a narrowing in the two-year differential of about 70 basis points contributed about 40 percent of peak cumulative appreciation.
  - By early November, yen appreciated by about 2 percent; later in November, with VIX above trend and net futures switching from short to long, yen strengthened by close to 7 percent over the episode.
  - Carry trade reversal functioned more as an amplifier than as a trigger.
- Episode 3 (December 2015–February 2016): China growth concerns and market uncertainty spike
  - Chinese equity prices fell by 18 percent between January 4 and January 18, 2016.
  - Net yen futures position turned from short to long in early January; VIX rose sharply.
  - Combined effects led to a cumulative yen appreciation vis-à-vis the U.S. dollar by over 3 percent by January 20, 2016.
  - VIX and carry trade reversal together explained more than 60 percent of the peak cumulative appreciation in the yen; the two-year differential contributed later.

### IV. VAR model specification and identification
- VAR follows Brunnermeier and others (2008) and adds a 10-year interest rate differential to capture growth-outlook differences.
- Endogenous variables (weekly-averaged where noted):
  - log(VIX)
  - 2-year US–JPN interest rate differential
  - 10-year US–JPN interest rate differential
  - Net futures position of non-commercial traders in yen
  - Average daily change in the U.S. dollar/yen exchange rate (averaged to weekly frequency)
- Identification and measurement
  - Cholesky decomposition used; ordering matters but main qualitative results largely unchanged across orderings.
  - Net futures positions proxied by net non-commercial traders’ long minus short futures positions as a fraction of total open interest (CFTC classification).
  - Historical decomposition used to estimate each factor’s contribution to exchange rate changes in the three episodes.

### V. Quantitative results and shocks
- Impulse response findings (reported magnitudes)
  - Uncertainty shock
    - A one-standard-deviation increase in log(VIX) (about 10 percent increase in the level of VIX) could lead to a 0.2 percent appreciation in the yen vs. the U.S. dollar in the first week (Figure 2).
    - Separately reported estimated effect: "0.4 percent during the first week."
    - Net futures position response to a VIX shock: about 1 percent reversal during the first week and 1.9 percent at its peak during the tenth week.
  - Interest rate shock
    - A one-standard-deviation narrowing in the two-year US–Japan interest rate differential (~0.1 percentage points) leads to yen appreciation effects (description in source truncated).
  - Carry trade shock
    - A one-standard-deviation pure speculative shock to carry trade activities (about an 8 percent decline in the net futures position of noncommercial traders in yen) could lead to a 0.6 percent appreciation in the yen against the U.S. dollar in the first week.
    - A one-standard-deviation shock to the net futures position produces statistically significant yen appreciation responses except when the net futures position is ordered last in the Cholesky decomposition (in which case it becomes statistically insignificant).
- Robustness and state dependence
  - Impulse responses to the 10-year differential qualitatively similar to the 2-year differential but with less statistical significance.
  - Main qualitative results hold when including EPFR fund flow data.
  - Error bands in impulse response figures are +/- 2 standard errors; horizons shown in weeks.
- Nonlinearity when VIX is high
  - When VIX is above its 90th percentile:
    - Impact of a one-standard-deviation increase in log(VIX) is about three times as large as compared to the full sample.
    - Carry trade position unwinds much faster in the first week—about two times the speed relative to when VIX is at its average.
  - The standard deviation of VIX did not change between the full sample and the high-VIX subsample, but transmission to exchange rates is amplified when uncertainty is high.

### VI. Flash Crash (January 4, 2019) — mechanics and contributions
- Intraday moves observed within a minute: Australian dollar 11 percent, Turkish lira 8 percent, U.S. dollar 4 percent (yen appreciation magnitudes reported in source).
- Likely drivers and mechanics
  - Low liquidity: event occurred during the "Asian witching hour" (daily low-liquidity period between New York close and Tokyo open); many Japanese market-maker banks closed for a public holiday; bid-ask spreads widened substantially.
  - Carry trade reversal: VIX surged amid pessimism over global growth; Japanese retail investors’ net long positions of high-yielding currency increased significantly; stop-loss triggers by carry traders were activated, leading to significant reversal in carry trade positions and increased demand for yen.
- Historical decomposition suggests carry trade reversal contributed substantially to the sharp yen appreciation; upward pressure diminished by the end of the witching hour but yen did not fully revert to pre-spike levels.

### VII. Distributional effects, skewness, and interest rate differential
- Kernel density analysis conditional on the two-year U.S.-Japan interest rate differential
  - Conditional densities for interest differential below 2.5 percent and greater than or equal to 2.5 percent show the distribution is skewed toward yen appreciation.
  - Almost no daily appreciation in the yen of over 1 percent when the interest rate differential was low; likelihood increases to about 1 percent when the interest rate differential is high.
- Skewness (three-month rolling daily U.S. dollar/yen movement, averaged to weekly frequency) added to VAR
  - Both the two-year interest rate differential and the carry trade reversal had statistically significant effects on skewness.
  - Effect of the two-year interest rate differential on skewness is significant in the medium term (a few months after the shock).
  - Effect of the carry trade reversal on skewness is very short lived.

### VIII. Policy implications and recommendations
- Carry trade is an important amplifier of yen appreciations via safe-haven channels and uncertainty shocks.
- U.S. monetary policy normalization combined with continued Japan Yield Curve Control may encourage unhedged carry trade activities and increase the likelihood of large yen appreciations when those positions reverse.
- Although a widening interest rate differential can depreciate the yen initially and benefit the Japanese economy, unwinding of increased carry trade positions could reverse depreciation and lead to rapid appreciations.
- Authorities should:
  - Keep in mind this exchange rate risk.
  - Continue to closely monitor carry trade activities.

*Source: wpiea2019136*

### References _______________________________________________________________ 17

### wpiea2019136 - References _______________________________________________________________ 17

### I. Introduction
- The paper examines drivers of rapid yen appreciations, emphasizing the amplifying roles of carry-trade activity and the zero lower bound (ZLB).
- Three main conclusions:
  - A rise in foreign interest rates tends to depreciate the yen but encourages carry trade (net short yen positions), increasing the likelihood of large yen appreciations when carry trades reverse.
  - Heightened uncertainty typically leads to yen appreciation via safe-haven effects, amplified by carry trade reversals; because Japanese interest rates are constrained by the ZLB, yen appreciation is likely to be more pronounced than that of other safe-haven currencies.
  - Carry trade reversals act as shock amplifiers; purely speculative shocks can trigger self-fulfilling appreciation cycles as yen appreciation prompts further carry trade reversals.
- Paper structure: Section II—drivers; Section III—three episodes; Section IV—VAR model; Section V—results; Section VI—conclusion.

### II. Main drivers of short-run yen dynamics
- Focus on three commonly cited short-term appreciation drivers:
  - Monetary policy shifts
    - Exchange rates reflect expected future interest rate differentials between foreign and domestic short-term rates.
    - Example mechanism: a sharp fall in current or expected U.S. short-term rates should immediately appreciate the yen vs. the U.S. dollar.
  - Safe haven effects
    - During risk-off episodes, investors move into perceived safe currencies (U.S. dollar, yen, Swiss franc); a rise in market uncertainty tends to appreciate the yen.
  - Carry trade reversals
    - Carry trade: borrow in a low-interest funding currency (yen) and invest in a high-interest target currency; profitable only if exchange rate moves do not eliminate carry.
    - Leveraged, unhedged positions mean funding-currency appreciation (or fear of it) can cause sharp unwinding and reinforce appreciation.
    - Japan’s near-zero interest rates for about two decades have made the yen a popular funding currency and particularly vulnerable to carry trade reversals.

### III. Three episodes of large and rapid yen appreciations (event study)
- Methodology:
  - Episodes identified via threshold methodology on appreciation size and sequencing of three drivers using quantitative and narrative records.
  - Variables: change in two-year U.S.-Japan interest rate differential (captures monetary policy shifts), VIX gap relative to its 60-day average (measures market uncertainty), net non-commercial yen futures position (captures unhedged carry trade positions).
  - Data frequency: daily for two-year differential, VIX, and exchange rate; weekly for net yen non-commercial position.
- Episode summaries and key magnitudes:
  - Episode 1 (April–June 2006): Risk aversion and carry trade reversal
    - Context: During 2005, U.S.-Japan two-year differential rose by around 100 basis points causing yen depreciation and expansion of carry trade positions.
    - Early 2006: unwind of carry trades led to a sharp yen appreciation of more than 5 percent in April–May, 2006.
    - VIX did not rise above its 60-day average until mid-May; two-year differential did not move significantly.
  - Episode 2 (October–November 2007): Financial stability concerns and U.S. monetary easing
    - September 2007: Fed cut federal funds rate by 50 basis points.
    - Two-year U.S.-Japan differential started to fall in mid-October and by end-November it had fallen by 100 basis points.
    - By early November, yen appreciated by about 2 percent; later in November, with VIX above trend and net futures switching from short to long, yen strengthened by close to 7 percent over the episode.
    - Carry trade reversal functioned more as an amplifier than as a trigger.
  - Episode 3 (December 2015–February 2016): China growth concerns and market uncertainty spike
    - Chinese equity prices fell by 18 percent between January 4 and January 18, 2016.
    - Net yen futures position turned from short to long in early January; VIX rose sharply.
    - Combined effects led to a cumulative yen appreciation vis-à-vis the U.S. dollar by over 3 percent by January 20, 2016.
    - ZLB likely contributed by squeezing the U.S.-Japan two-year interest rate differential.
- Cross-episode insights:
  - Rising global interest rates can induce large unhedged carry trade positions that become vulnerable to reversal.
  - Triggers vary: rise in risk perception (2006), policy switch (2007), increase in market uncertainty (2016).
  - During risk-off episodes, flows into perceived safe assets and the ZLB on Japanese yields can squeeze interest differentials and amplify yen appreciation—even versus other safe-haven currencies.

### IV. Disentangling exchange rate drivers using a VAR model
- VAR specification follows Brunnermeier and others (2008); adds 10-year interest rate differential to capture growth-outlook differences.
- Endogenous variables (weekly-averaged where noted):
  - log(VIX)
  - 2-year US–JPN interest rate differential
  - 10-year US–JPN interest rate differential
  - Net futures position of non-commercial traders in yen
  - Average daily change in the U.S. dollar/yen exchange rate (averaged to weekly frequency)
- Identification:
  - Cholesky decomposition used; ordering matters. Re-running with different orderings leaves main qualitative results largely unchanged.
  - Historical decomposition used to estimate each factor’s contribution to exchange rate changes in the three episodes.

### V. Results
- Impulse response findings (Figure 2):
  - Shocks analyzed: one-standard-deviation shocks to log(VIX), the 2-year differential, and the net futures position (carry trade reversal).
  - Uncertainty shock:
    - A one-standard-deviation increase in log(VIX) (about 10 percent increase in the level of VIX) could lead to a 0.2 percent appreciation in the yen vs. the U.S. dollar in the first week.
    - Net futures position response to VIX shock: about 1 percent reversal during the first week and 1.9 percent at its peak during the tenth week.
  - Interest rate shock:
    - A one-standard-deviation narrowing in the two-year US–Japan interest rate differential (~0.1 percentage points) leads to yen appreciation effects (continued description truncated in source).
  - Carry trade shock:
    - A one-standard-deviation shock to the net futures position (carry trade reversal) produces statistically significant yen appreciation responses, though significance depends on Cholesky ordering (becomes statistically insignificant only when ranked last).
- Robustness notes:
  - Impulse responses to 10-year differential qualitatively similar to 2-year differential but with less statistical significance.
  - Main qualitative results hold when including EPFR fund flow data.
  - Error bands in impulse response figures are +/- 2 standard errors; horizons shown in weeks.
- Data and measurement notes:
  - Net futures positions are proxied by net non-commercial traders’ long minus short futures positions as a fraction of total open interest (CFTC classification).
  - This captures derivatives-based carry trade activity through futures (not forward contracts) but is considered a valid indicator as non-commercial traders are speculators who use futures in carry trades.
  - Daily observations used for most series; weekly for net futures positions.

*Source: wpiea2019136 - References _______________________________________________________________ 17*

### 0.4 percent during the first week.

### wpiea2019136 - 0.4 percent during the first week.

### Key findings on channels and shocks
- A one-standard-deviation increase in log(VIX) can lead to yen appreciation; an estimated effect of "0.4 percent during the first week."
- A one-standard-deviation pure speculative shock to carry trade activities (about an 8 percent decline in the net futures position of noncommercial traders in yen) could lead to a 0.6 percent appreciation in the yen against the U.S. dollar in the first week.
- Rising U.S. interest rates that widen the U.S.-Japan interest rate differential could encourage carry trade activities and depreciate the yen; conversely, a narrowing in the interest rate differential (for example, U.S. rates declining while Japan remains constant under Yield Curve Control) can contribute to yen appreciation.
- Carry trade reversal acts as an amplification channel for yen appreciation when uncertainty rises; a shock to the exchange rate can lead to further reversal in carry trade positions, potentially triggering a self-fulfilling appreciation cycle.

### Nonlinearity and state dependence (high VIX)
- When VIX is above its 90th percentile:
  - The impact of a one-standard-deviation increase in log(VIX) is about three times as large as compared to the full sample.
  - The carry trade position unwinds much faster in the first week—about two times the speed relative to when VIX is at its average.
- The standard deviation of VIX did not change between the full sample and the high-VIX subsample, but the transmission to exchange rates is amplified when uncertainty is high.

### Historical decomposition: three episodes of large yen appreciation
- Spring 2006 (rising risk perception and carry trade reversal):
  - The carry trade reversal alone explains over 40 percent of the peak cumulative appreciation of the yen.
  - Depreciation effects from a decline in the VIX at the beginning of the episode and a widening in the 10-year interest rate differential mitigated the appreciation.
- 2007 (financial stability concerns and U.S. monetary easing):
  - A narrowing in the two-year interest rate differential between the U.S. and Japan (by about 70 basis points) contributed about 40 percent of the peak cumulative appreciation in the yen.
- 2016 (heightened uncertainty and China growth concerns):
  - VIX and carry trade reversal together explained more than 60 percent of the peak cumulative appreciation in the yen.
  - The two-year interest rate differential contributed to appreciation but only at a later stage.

### Flash Crash of the yen (January 4, 2019)
- Intraday moves:
  - Yen appreciation within a minute: Australian dollar (11 percent), Turkish lira (8 percent), U.S. dollar (4 percent).
- Likely drivers and mechanics:
  - Low liquidity: event occurred during the "Asian witching hour" (daily low-liquidity period between New York close and Tokyo open); many Japanese market-maker banks were closed for a public holiday; bid-ask spreads widened substantially.
  - Carry trade reversal: VIX surged amid pessimism over global growth; Japanese retail investors’ net long positions of high-yielding currency increased significantly; stop-loss triggers by carry traders were activated, leading to significant reversal in carry trade positions and increased demand for yen.
- Historical decomposition from the VAR model suggests carry trade reversal contributed substantially to the sharp yen appreciation during the episode.
- By the end of the witching hour, upward pressure diminished but the yen did not fully revert to pre-spike levels.

### Distributional effects, skewness, and interest rate differential
- Kernel density analysis conditional on the two-year U.S.-Japan interest rate differential:
  - Conditional densities for interest differential below 2.5 percent and greater than or equal to 2.5 percent show the distribution is skewed toward yen appreciation.
  - There was almost no daily appreciation in the yen of over 1 percent when the interest rate differential was low; such likelihood increases to about 1 percent when the interest rate differential is high.
- Skewness measure (three-month rolling daily U.S. dollar/yen movement, averaged to weekly frequency) added to VAR:
  - Both the two-year interest rate differential and the carry trade reversal had statistically significant effects on skewness.
  - The effect of the two-year interest rate differential on skewness is significant in the medium term (a few months after the shock).
  - The effect of the carry trade reversal on skewness is very short lived.

### Policy implications and recommendations
- Carry trade is an important amplifier of yen appreciations via safe-haven channels and uncertainty shocks.
- U.S. monetary policy normalization combined with continued Japan Yield Curve Control may encourage unhedged carry trade activities and increase the likelihood of large yen appreciations when those positions reverse.
- Although a widening interest rate differential can depreciate the yen initially and benefit the Japanese economy, unwinding of increased carry trade positions could reverse depreciation and lead to rapid appreciations.
- Authorities should:
  - Keep in mind this exchange rate risk.
  - Continue to closely monitor carry trade activities.

*Source: IMF staff estimates and analysis in wpiea2019136.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019136.pdf_