Funding Currencies Explained: Why JPY and CHF Matter in Global Markets

What Are Funding Currencies?

Funding currencies are currencies that investors borrow to invest in higher-yielding currencies. This is the "funding leg" of a carry trade. The logic is simple: if you can borrow yen at 0.1% and invest in Australian dollars at 4%, you earn the 3.9% interest rate differential (the "carry"). As long as the exchange rate does not move against you, you profit from the interest rate gap.

The Japanese yen (JPY) and Swiss franc (CHF) are the classic funding currencies because Japan and Switzerland have historically maintained some of the lowest interest rates in the developed world. The Bank of Japan kept rates near or below zero for decades, and the Swiss National Bank has maintained low or negative rates for extended periods. These low rates make JPY and CHF attractive currencies to borrow for carry trades.

Funding currencies are central to understanding how global capital flows. When carry trades are being built (risk-on), funding currencies are sold. When carry trades are being unwound (risk-off), funding currencies are bought back. This is why JPY and CHF often strengthen during market stress, even though they are not the highest-yielding or most fundamentally strong currencies.

Why Low Rates Make a Currency a Funding Candidate

A currency becomes a funding candidate when its central bank maintains interest rates below those of other major economies. The interest rate differential — the gap between the funding currency's rate and the investment currency's rate — is the "carry" that investors earn. The larger the differential, the more attractive the carry trade.

The Bank of Japan has kept rates near zero for decades, first to combat deflation and later to support economic growth. The Swiss National Bank has maintained low or negative rates to prevent excessive franc appreciation, which would hurt Swiss exports. These persistently low rates make JPY and CHF natural funding currencies.

The key point is that funding status is driven by relative interest rates, not absolute rates. If Japan raises rates to 2% but the US raises rates to 6%, the yen remains a funding currency because the rate differential still favours borrowing yen and investing in dollars. Funding status depends on the gap, not the level. See Interest Rate Differentials.

Funding Currencies and Carry Trades

Carry trades are the primary mechanism through which funding currencies affect FX markets. A carry trade involves:

1. Borrowing a low-yielding currency (the funding currency, e.g., JPY).
2. Converting it to a higher-yielding currency (the investment currency, e.g., AUD).
3. Investing in higher-yielding assets in that currency.
4. Earning the interest rate differential (the carry) over time.

The risk is that the exchange rate moves against the trade. If the funding currency appreciates against the investment currency, the FX loss can exceed the carry earned. This is why carry trades are vulnerable to volatility spikes — when volatility rises, the risk of an adverse FX move increases, and investors unwind their carry trades to lock in profits and reduce risk.

When carry trades are unwound, investors sell the investment currency and buy back the funding currency. This is why funding currencies tend to strengthen during volatility spikes. The unwinding of carry trades creates demand for the funding currency, pushing its exchange rate higher. See Carry Trades for the full mechanics.

Funding Currencies During Volatility Spikes

The relationship between funding currencies and volatility is one of the most important dynamics in FX markets. During normal, low-volatility periods, carry trades are profitable and funding currencies are sold. During volatility spikes, carry trades are unwound and funding currencies are bought back.

This dynamic is amplified by leverage. Carry trades are often leveraged — investors borrow more than their own capital to increase the carry earned. When volatility rises, margin requirements increase, and leveraged investors may be forced to unwind their positions. Forced unwinding creates cascading demand for the funding currency, which can produce sharp, one-directional moves.

This is why the yen often strengthens sharply during equity market sell-offs or geopolitical crises. The yen is not strengthening because Japan's fundamentals are improving — it is strengthening because carry trades funded in yen are being unwound. The same dynamic applies to the Swiss franc, though the SNB's intervention can sometimes dampen CHF moves. See FX Volatility and VIX and Forex.

Funding Currencies vs Safe Havens

Funding currencies and safe havens are not the same concept, though JPY and CHF often serve both roles. The distinction matters:

• Funding currency: A currency that is borrowed for carry trades because of its low interest rate. It strengthens when carry trades are unwound.
• Safe haven: A currency that attracts capital during crises because of its stability, liquidity and institutional quality. It strengthens when investors seek safety.

The Japanese yen is both a funding currency and a safe haven. It is a funding currency because of Japan's low rates, and it is a safe haven because of Japan's large current-account surplus, stable institutions and status as the world's largest net creditor nation. The Swiss franc is also both — a funding currency because of Swiss low rates, and a safe haven because of Switzerland's political neutrality, strong institutions and current-account surplus.

However, not all funding currencies are safe havens, and not all safe havens are funding currencies. The US dollar is a safe haven but is not typically a funding currency (because US rates are usually higher than Japanese or Swiss rates). A currency could theoretically be a funding currency without being a safe haven, if it had low rates but weak institutions. See Safe-Haven Currencies for the safe-haven mechanism.

Why Funding Status Is Not Permanent

Funding status is not a permanent characteristic — it depends on the interest rate differential, which can change. If a central bank raises rates significantly while other central banks keep rates low, its currency may lose its funding-currency status.

For example, if the Bank of Japan were to raise rates aggressively while the Federal Reserve kept rates low, the yen could lose its status as a funding currency. Investors would no longer borrow yen to invest in dollars, because the rate differential would have narrowed or reversed. This would reduce the amount of yen-funded carry trades and could change the yen's behaviour during volatility spikes.

Conversely, a currency that is not currently a funding currency could become one if its central bank cuts rates aggressively. If the Federal Reserve cut rates to zero while other central banks maintained higher rates, the dollar could become a funding currency. This is what happened briefly during the COVID crisis in 2020, when the Fed cut rates to near zero and the dollar was used as a funding currency for a short period. See Negative Interest Rates.

The Role of Central Bank Policy Divergence

Funding currency dynamics are driven by central bank policy divergence — the gap between one central bank's policy and another's. When the Bank of Japan maintains ultra-low rates while the Federal Reserve raises rates, the policy divergence widens the interest rate differential, making yen-funded carry trades more attractive. When central banks move in the same direction (e.g., all cutting rates), the differentials narrow and carry trades become less attractive.

Policy divergence is why the yen's funding-currency status has been so persistent. While the Fed, ECB and other central banks have raised and lowered rates over the years, the Bank of Japan has maintained ultra-low rates for decades. This persistent divergence has kept the yen as the world's primary funding currency. See Policy Divergence.

However, policy divergence can shift. If the Bank of Japan begins to normalise rates while other central banks cut, the divergence narrows and the yen's funding-currency role may diminish. This is a structural shift that can change the behaviour of JPY pairs over time.

Funding Currencies in Risk-On vs Risk-Off

Funding currencies behave differently in risk-on and risk-off environments:

• Risk-on: Investors build carry trades. They sell funding currencies (JPY, CHF) and buy higher-yielding currencies (AUD, NZD, MXN). Funding currencies tend to weaken. High-beta currencies tend to strengthen.
• Risk-off: Investors unwind carry trades. They sell higher-yielding currencies and buy back funding currencies. Funding currencies tend to strengthen. High-beta currencies tend to weaken.

This risk-on/risk-off dynamic is one of the most reliable patterns in FX markets, but it is not mechanical. The strength of the effect depends on the size of carry-trade positioning, the level of volatility, and the monetary-policy context. If carry positioning is light, a volatility spike may not produce significant funding-currency strength. If a central bank is expected to ease, its currency may weaken despite risk-off flows. See Risk-On vs Risk-Off.

Why Some Currencies Become Funding Candidates and Others Do Not

Not all low-rate currencies become funding currencies. Several factors determine whether a currency is used as a funding currency:

• Interest rate level: The currency must have low rates relative to other currencies. This is the primary requirement.
• Liquidity: The currency must be liquid enough to be borrowed and sold in large quantities. JPY and CHF are highly liquid; smaller currencies may not be.
• Stability: The currency must be relatively stable. Investors are reluctant to borrow a currency that might appreciate sharply, as that would create FX losses on the funding leg.
• Capital mobility: The currency must be freely tradable, without capital controls. Currencies with capital controls cannot be easily borrowed by international investors.
• Size of the market: The currency's market must be large enough to absorb the borrowing demand. Small currencies may not have sufficient depth.

The Japanese yen meets all these criteria: low rates, high liquidity, relative stability (until carry unwinds), free capital mobility and a large market. This is why JPY is the world's primary funding currency. The Swiss franc also meets these criteria, though its smaller market size means it is less used than JPY. See What Drives the Japanese Yen and What Drives the Swiss Franc.

Funding Currencies and Global Liquidity

Funding currencies are intimately linked to global liquidity conditions. When global liquidity is abundant — central banks are easing, credit is available, volatility is low — carry trades flourish and funding currencies are sold. When global liquidity tightens — central banks tighten, credit becomes scarce, volatility rises — carry trades are unwound and funding currencies strengthen.

This link is why funding currencies are sometimes called "liquidity proxies." The yen's exchange rate can be read as a signal of global liquidity conditions: a weak yen suggests abundant liquidity and active carry trades; a strong yen suggests tightening liquidity and carry unwinds. See Global Liquidity and Forex.

The link between funding currencies and global liquidity also explains why central bank policy has such a large impact on FX markets. When the Federal Reserve eases, it increases global dollar liquidity, which can support carry trades and weaken funding currencies. When the Fed tightens, it reduces global dollar liquidity, which can trigger carry unwinds and strengthen funding currencies.

Negative Interest Rates and Funding Currencies

Negative interest rates — where the central bank charges banks for holding deposits — make a currency an even more attractive funding candidate. When the Swiss National Bank introduced negative rates in 2015, the Swiss franc became an even more attractive funding currency. When the Bank of Japan introduced negative rates in 2016, it reinforced the yen's funding-currency status.

Negative rates create an unusual dynamic: investors are effectively paid to borrow the currency (or at least, they face a very low or zero borrowing cost). This makes carry trades even more attractive, because the funding cost is minimal. However, negative rates also signal that the central bank is concerned about deflation or currency appreciation, which can create conflicting signals for the currency.

See Negative Interest Rates for the full implications of negative rate policy.

Common Mistakes

• Confusing funding currencies with safe havens: Funding currencies strengthen due to carry unwinds; safe havens strengthen due to safety demand. JPY and CHF are both, but the mechanisms are different.
• Assuming funding status is permanent: Funding status depends on the interest rate differential. If the differential narrows or reverses, the currency may lose its funding status.
• Assuming JPY always strengthens in risk-off: JPY typically strengthens in risk-off due to carry unwinds, but if the Bank of Japan is expected to ease, JPY may weaken instead.
• Ignoring positioning: If carry trades are not crowded, a volatility spike may not produce significant funding-currency strength.
• Ignoring the type of shock: A US-specific shock may produce different funding-currency dynamics than a global shock.
• Using funding status as a standalone signal: Funding status is most useful when combined with volatility, positioning and monetary-policy context.

Practical Framework for Analysing Funding Currencies

1. Check the interest rate differential: Is the currency's rate below the rates of other major economies? Is the differential widening or narrowing?
2. Check central bank policy divergence: Is the central bank maintaining low rates while others tighten? Is there a risk of policy normalisation?
3. Check volatility: Is the VIX low (carry trades active) or elevated (carry trades being unwound)? See VIX and Forex.
4. Check carry-trade positioning: Are carry trades crowded? Is there a risk of rapid unwinds? See Positioning Extremes.
5. Check global liquidity: Is global liquidity abundant or tightening? Are central banks easing or tightening?
6. Apply to the specific pair: If you are trading AUD/JPY, the yen's funding status is directly relevant. If you are trading EUR/USD, it is less relevant.
7. Watch for regime changes: If the central bank begins to normalise rates, the currency's funding status may change, which can alter its behaviour during volatility spikes.

Funding currencies are a critical part of the global FX system. MacroDrivers® evaluates currencies using relative macro conditions — growth, inflation, rates, central-bank stance, risk and positioning — rather than relying on a single label. Understanding funding-currency dynamics provides useful context, but it does not replace analysing both currencies in the specific pair you are trading.

Related Reading

• Carry Trades
• Safe-Haven Currencies
• What Drives the Japanese Yen
• What Drives the Swiss Franc
• Negative Interest Rates