Unwinding the Carry Trade
On the 5th of August, the global markets suffered a meltdown, unleashed by a policy shift from the Bank of Japan and reignited fears of a US Recession. In this article, we’ll look into how the policy shift from the BoJ caused an unraveling of the Japanese yen carry trade.
But first, what is the carry trade?
It is broadly defined as using a low-yielding currency to buy higher-yielding foreign assets. So for the Yen carry trade, it involves borrowing the Japanese yen with low interest rates and then using it to invest in assets that generate attractive returns.
These assets could range from tech stocks to government bonds. As long as the Yen stays low against the US dollar, the investor can pay back what was borrowed and still make a profit.
The Yen carry trade has been popular among investors because Japan was giving out “free money” as it kept its borrowing costs ultra-low. The Bank of Japan has not raised rates since 2007, 17 years ago, keeping it between 0 and - 0.1%.
During this same period, the Japanese Yen had weakened steadily against the US Dollar, with the USDJPY rising to historic highs of 160 by mid-2024. And as the yen kept falling, the loans became even cheaper to repay, and the payoffs became that much bigger.
The BOJ Changes Its Stance in March 2024
Following several unsuccessful currency interventions to manage the weakness of the Japanese Yen, finally, in March 2024, the BoJ decided to end its negative rates regime by hiking rates to 0.1% after 17 years. This decision was not so much because of the Yen weakness but was mainly because the BoJ’s 2% inflation target was in sight after wages showed strong salary increases of 5.3% at large firms and also that the BoJ believed wages would continue to increase steadily. But because the BoJ said that financial conditions are set to remain "accommodative" and gave no signals on further interest rate hikes, the impact on the Japanese Yen was minimal and actually, it continued to weaken against the US dollar.
Fast Forward to July 2024
On July 11th the US CPI was released at 3%, signaling a steady slowdown in inflation growth, toward the Federal Reserve’s inflation target level of 2-3%. This alerted markets that the Federal Reserve could decide to begin cutting its interest rates as soon as at the September meeting.
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Then on the 31st of July, the BOJ surprised markets by raising interest rates to a 15-year high of 0.25% and that they would reduce the rate of bond buying significantly. The combination of the 2 news had a massive impact as the yen rose 14% against the dollar in less than a month between July 10 to August 5.
The yen’s appreciation mirrored past episodes, such as the 1998 Long-Term Capital Management hedge fund collapse and the 2007 subprime mortgage crisis, where the yen appreciated 20% from its low.
So now we have a dangerous concoction
1) Investors borrowing huge amounts of Japanese Yen
2) Speculation of rate cuts for the US
3) Anticipation that the BoJ could hike rates further
This led to growing fear from the investors that history could repeat itself, traders dumped assets to meet margin calls, resulting in a massive selloff in equities and other currencies. Trillions of dollars were erased from equity values around the world where the Nikkei 225 erased all its gains this year as it dropped by 12.4%, the worst day since the “Black Monday” of 1987, the S&P500 and DJI fell by 4%, and 3% respectively.
As quickly as the global markets crashed, it recovered the very next day. Probably helped by the BoJ suddenly announcing that they would not be hiking rates during volatile market conditions. Casting some doubt and uncertainty over their conviction along this path of monetary tightening.
It is unlikely that the market will go back to a carry environment anytime soon with the Fed cutting and the BoJ hiking and depending on what you’ve read, many analysts have indicated that the unwinding is about half done.
But watch out for possible signaling of rapid interest rate cuts from the Federal Reserve which could make matters worse for the global carry trade. Further sell-off could even prompt a recession, given negative wealth effects and tighter credit conditions.
Ultimately, there will be a lot more volatility and possible bigger shocks coming for the market. But, only with volatility comes great opportunities.
Please remember, to trade safe and invest smart.