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What is the Yen “Carry Trade” That Has Been Roiling the Markets?
August 6, 2024
The markets got off to a rocky start this week. Concerns about a slowing U.S. economy have unsettled investors, but one major factor in the recent turmoil has been the unraveling of a popular investment strategy known as a “carry trade.”
A carry trade is when an investor takes out a loan in a country with low interest rates, such as Japan or China, and uses those borrowed funds to invest in a currency with higher interest rates, such as Mexico’s.
In recent years, Japan’s exceptionally low interest rates have made the yen the preferred currency for such trades. Japan has been something of an outlier as central banks throughout the world have been raising rates to address inflation. The Bank of Japan had kept rates below zero through April, and unexpectedly raised rates again late last month.
The success of a carry trade relies on the borrowing currency staying inexpensive and market volatility remaining low. However, both of these conditions have recently shifted, with the yen strengthening and markets experiencing increased instability.
The yen has surged 7.5% over the past week, severely impacting carry traders. Investors who had borrowed yen faced margin calls as the currency’s value increased, meaning their banks demanded additional collateral. In response, these investors have had to purchase more yen to cover their existing positions, driving the yen’s value even higher and triggering further margin calls.
Getting a sense of how widespread such carry trades are can be difficult, as currency transactions are not centrally tracked the way trades in the stock market are. The Wall Street Journal has tried to get a clearer picture by looking at contracts tracked by the Commodity Futures Trading Commission. Their analysis found that speculative investors were holding more than 180,000 contracts betting on a weaker, totaling more than $14 billion, at the beginning of July. As of last week, those positions had been cut to around $6 billion.
The yen may continue to strengthen as investors attempt to hedge against losses. Hedging currency risk has been costly in recent years, leading some investors and banks with yen exposure to avoid it. Even institutional investors in Japan, such as life insurance companies, have reduced their hedging on their large holdings of foreign bonds. If hedging activities increase, it would boost demand for the yen. This could create a vicious cycle, wherein the yen’s strengthening prompts investors to cover their positions by purchasing more yen, driving up the value even more.
