What is carry trade? Yen carry trade explained & its impact

When markets plunged on August 5, many asked: What is a carry trade? Discover how this financial strategy is quietly fueling chaos and causing staggering losses globally.

August 5, 2023, will go down in history as one of the most volatile days in recent financial history. It was a day when markets were shaken and investors lost billions of dollars in a matter of hours.

Dubbed ‘Crypto Black Monday,’ the cryptocurrency market experienced a massive sell-off, with total market value dropping from $2.16 trillion on August 4 to $1.78 on August 5, a drop of nearly 18%.

But the shockwaves were not limited to the crypto world. Major global stock indices such as the NASDAQ100 in the US, the FTSE100 in the UK and India’s NIFTY50 all experienced sharp declines, leaving investors stunned.

Japan’s Nikkei225 index fell nearly 12.5% ​​in a single trading session, its biggest drop since 1987. It was a red day for all indexes.

While there are a multitude of reasons for this market turmoil – from fears of an impending recession in the US to rising geopolitical tensions in West Asia – one factor has stood out above all others: the unwinding of the yen carry trade.

This term may sound complicated, but it is crucial to understand the domino effect that led to the global financial turmoil.

So what does carry trade mean and how does it wield so much power over the markets? Let’s dive deeper into this concept, break it down, and examine how it plays a huge role in market chaos.

What is carry trade?

The term “carry trade” may sound fancy, but it’s actually a pretty simple concept when you break it down.

Imagine borrowing money from one country at a very low interest rate and then investing that borrowed money in another country where interest rates are much higher. The goal? To pocket the difference between the lower cost of borrowing and the higher return.

Let’s say you borrow Japanese yen, which typically has very low interest rates, and use it to invest in U.S. dollars, which typically offer higher interest rates. The profit you make from the difference is what traders call your “carry.”

But here’s the thing: carry trading isn’t just a random strategy used by a handful of traders. It’s a massive global phenomenon that can involve trillions of dollars moving across borders. In fact, it’s one of the reasons why certain currencies, like the yen, see such huge daily trading volumes.

Carry trades can have a big impact on global financial markets. When popular, they can boost the value of currencies offering higher returns.

But when investors start closing out their carry trades, that is, closing out these positions, it can lead to sharp moves in the markets, as we have seen recently with the yen.

Let’s understand with a few examples.

Carry trade examples An investor who borrows yen at 0.1% converts it into Australian dollars and buys bonds yielding 5%, hoping to profit from the difference in interest rates. An investor who borrows Swiss francs at 0.5% converts it into Turkish lira and invests in Turkish real estate, benefiting from higher returns but risking currency fluctuations. An investor who borrows euros at a low rate and invests in Brazilian agricultural stocks, hoping to profit from Brazil’s strong export growth. An investor who borrows US dollars at 2% converts it into Indian rupees and buys high-yielding Indian corporate bonds, hoping to earn better returns while managing currency risk. An investor who borrows British pounds at a low rate invests in South African mining stocks, hoping to profit from rising commodity prices but being wary of the rand’s volatility. How does a carry trade work?

Now that we know what a carry trade is, let’s take a look at how it works.

Imagine you are a trader who has the ability to borrow Japanese yen at a super low interest rate, say 0.5%. You borrow 1 million yen and then convert that yen into US dollars.

The reason you convert it is because you know that in the US you can invest that money in bonds that offer a 4% interest rate. So, you take your converted dollars and buy US bonds.

This is where the magic happens. You pay just 0.5% interest on the yen you borrow, but you earn 4% on your U.S. bonds. The difference, 3.5%, is your profit—the “carry” in a carry trade.

But bonds aren’t the only places investors are parking their money. Some people are aiming for higher returns by investing borrowed funds in stocks.

Let’s say you took that same 1 million yen, converted it into US dollars, and bought shares of a company like Apple or Tesla.

If those stocks increase in value by 10%, you not only retain the profit from the stock increase, but you also continue to benefit from the lower interest rate on your original loan.

For example, if Apple stock gains 10% and you sell your stock, the profit you make from the stock gain could be much higher than the interest you would have paid on the yen you borrowed.

But if stock prices fall or the yen strengthens against the dollar, your profits can quickly evaporate or worse, turn into losses.

Traders around the world participate in carry trades in all types of currencies, not just yen and dollars. For example, borrowing Swiss francs (which also have lower interest rates) and investing in Australian dollars (which usually offer higher interest rates) is another popular carry trade.

The key is always the same: Find a currency you can borrow cheaply in and another currency you can invest in for higher returns.

Carry trades are popular because they can increase returns when the market is favorable. However, they also come with risks. That’s why some say carry trades are like “picking pennies in front of a steamroller.” There is potential for profit, but the risks can be just as great.

The impact of yen carry trade on global markets

Yen carry trading has been a popular strategy for investors for years thanks to Japan’s ultra-low interest rates. The Bank of Japan has kept its benchmark interest rate at nearly zero for a long time, even dropping into negative territory of -0.10% since 2016.

This policy was designed to stimulate economic activity by making borrowing cheaper. However, since Japan is a major global economy, these low rates have far-reaching effects beyond its borders.

How big is the yen carry trade?

Global markets suffered significant losses on Monday amid growing fears that yen carry trading is declining.

According to Deutsche Bank, yen carry trades are worth $20 trillion, equivalent to 505% of Japan’s gross domestic product. picture.twitter.com/bSYtJaHL0t

— Kobeissi Letter (@KobeissiLetter) August 8, 2024

In this context, the Japanese yen carry trade works like this: Investors borrow yen at these low interest rates and then convert the yen into other currencies and invest in higher-yielding assets abroad.

For example, they might invest in bonds, stocks, or real estate in countries where yields are higher, such as Brazil, Mexico, India, or the United States.

The difference between the lower cost of borrowing in Japan and the higher returns on these foreign investments creates profits—a strategy that has raked in trillions of dollars over time.

But things change in 2024. On March 19, the BOJ raised interest rates for the first time since 2007. Then, on July 31, it raised rates again, taking the reference rate to “around 0.25%” from the previous range of 0% to 0.1%.

This may seem like a small change, but it was a big change for Japan, where interest rates have been very low for a long time.

This rate hike had two immediate effects. First, it made borrowing in yen more expensive, which reduced the profitability of the carry trade.

Second, it led to a strengthening of the yen against other currencies, meaning that when investors converted their foreign investments back into yen, they received less value than before.

As a result, the Japanese Yen strengthened and the USD/JPY currency pair fell to its lowest level since December 2023.

Whereas a few weeks ago you received 160 yen for every US dollar, you now receive 142 yen for every US dollar.

But the real point is this:

(5/7) picture.twitter.com/pXzfHtUdwR

— Kobeissi Letter (@KobeissiLetter) August 5, 2024

As a result, many investors began to wind down their carries – essentially selling off their foreign assets to repay yen loans. This mass sell-off caused a ripple effect across global markets.

Stocks, bonds and other assets backed by yen carry trade investments began to lose value. The sudden increase in demand for yen caused the currency to appreciate even more, adding to the losses of those still holding foreign assets.

Risks and rewards

Before diving into carry trades, it’s important to weigh the potential rewards against the risks involved.

Carry trade rewards Interest rate differentials: The primary reward is the profit made from the interest rate differential between two countries. Borrowing at a lower rate and investing at a higher rate allows investors to pocket the difference.
High return potential: When investing in high-yielding assets like stocks, the potential returns can be much higher, pushing the profit beyond just the interest rate differential.
Leverage: Carry trades often require taking on large amounts of debt, which can increase profits when the trade works in your favor.
Steady income stream: When done correctly, carry trades can provide a steady and predictable income stream, especially when interest rates remain stable and favorable. Risks of carry trades Currency fluctuations: A change in the value of the borrowed currency (e.g. yen) can lead to losses when it is recycled to repay the loan, especially if the borrowed currency strengthens against the deposited currency.
Market volatility: Investments made with borrowed funds, such as stocks or bonds, may lose value and result in losses rather than expected profits.
Interest rate changes: If interest rates in the country you borrow from increase, your borrowing costs may increase, reducing or eliminating your profit margin.
Liquidity risk: In times of market stress, it can be difficult to exit a carry trade quickly without incurring large losses, especially if everyone else is trying to do the same thing.

The recent market turmoil sparked by the unwinding of the yen carry trade shows just how powerful and risky this strategy can be.

Ultimately, carry trades are a balancing act between risk and reward, and understanding both sides of the equation is important to making smart investment decisions.

Disclosure: This article does not provide investment advice. The content and materials contained on this page are for educational purposes only.