The Carry Trade - From Glory to Demise
A look into the USD/YEN carry-trade and how it affects global financial markets at a high-level.
Understanding the Carry Trade
A carry trade is a financial strategy where investors borrow funds in a currency with a low-interest rate and invest them in a currency offering a higher return. The goal is to capitalize on the interest rate differential to generate profits.
The Yen Carry Trade Explained
One of the most widely used carry trades involves borrowing Japanese yen—which has historically low interest rates—and investing in assets denominated in U.S. dollars or other high-yield currencies. The mechanics are as follows:
Borrowing Yen – Investors secure yen loans at low interest rates.
Investing in Higher-Yield Assets – The borrowed funds are used to purchase assets like bonds offering better returns.
Earning Profits – Investors benefit from the interest rate differential, earning more on their investment than what they pay for borrowing the yen.
Currency Appreciation – If the high-interest-rate currency strengthens, investors can repay their yen loans with more favorable exchange rates, increasing overall gains.
For instance, if an investor borrows yen at 1% and invests in U.S. assets yielding 4%, they profit from the 3% spread, minus transaction costs.
Risks of the Carry Trade
While appealing, carry trades come with risks:
Exchange Rate Volatility – If the yen appreciates significantly or the dollar depreciates, repaying the yen loan becomes costly.
Market Disruptions – Major currency shifts may trigger forced liquidations, leading to financial losses.
Systemic Impact – Large-scale unwinding of carry trades can cause volatility across global markets.
What is happening to the Yen?
The Yen has fallen to a 38-year low this year (2024) against the U.S. dollar. Consequently, the Bank of Japan (BOJ) intervened by unexpectedly increasing its benchmark interest rate by 15 basis points to date to approximately 0.25% amid inflation concerns and currency depreciation. Notably, the BOJ's interest rate has ranged from 0% to 0.5% since 1999, even experiencing a period of negative interest rates. The Yen has been under continuous strain since the BOJ ended its negative interest rate policy in March.
Since the BOJ ended negative interest rates in March 2024, investors engaged in carry trades are increasingly concerned that the once "free money" they borrowed now comes at a cost. Many have started unwinding their positions and repaying loans, impacting global financial flows.
Why does this matter?
While a 0.25% increase might not appear significant, particularly when compared to U.S. bonds that have climbed between 4-5%, it's crucial to recognize that any reduction in the spread (the difference between interest rates) adversely affects investors. It's important to account for all fees, charges, and taxes in addition to the borrowing costs to stay profitable.
With the U.S. economy facing recessionary pressures, bond yields are likely to decrease in the upcoming quarters, which will worsen the spread for those involved in carry trades.
It's also crucial to consider the effect of currency strength. Typically, when interest rates increase, so does currency strength. Conversely, when interest rates fall, currency strength tends to weaken. Therefore, if U.S. bond interest rates are expected to drop, the U.S. dollar is likely to weaken, making it costlier to purchase or borrow foreign currencies, thereby diminishing the advantages of a carry trade.
What is the impact globally?
Given the carry trade's popularity and the substantial spread over the years, major institutional investors have borrowed trillions of Yen and funneled these funds into diverse financial markets. Should there be any disruption in the carry trade dynamics, these institutions would need to unwind and liquidate their assets. This could lead to a large-scale withdrawal of funds from financial markets, resulting in significant volatility in global markets.
The BOJ truly does have a major influence
The BOJ’s actions can set off a chain reaction in the global markets. If the BOJ decides to intervene again and raise interest rates in Japan, it can cause a short squeeze where investors start selling off their investment in other parts of the world to pay back their loans denominated in Yen. This results in the value of the Yen rising quickly with increase in demand. The sudden selling, as discussed earlier, can lead to a global margin call where a chain reaction ensues where one investor selling causes a multitude of others to sell as well.
So where does the money flow thereafter?
A flight to safety - investors often opt to invest directly in safer assets such as bonds, causing their value to increase, while riskier assets like equities tend to decline. This shift can lead to significant economic impacts, influencing consumer confidence, capital growth, and overall economic prosperity.
Conclusion
Carry trades necessitate numerous components for success, including substantial interest rate differentials between currencies, as well as favorable economic conditions and political stability. Misalignment of these factors can result in significant global repercussions. As for the yen carry trade, the more interest rate spreads collapse, the more likely the yen will strengthen versus the U.S. dollar, and the more the trade will unwind causing more bad news in the financial markets.
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