What is the Yen Carry Trade and Why Should I Care?

You may have been hearing more about the so-called “Yen carry trade” lately. But what exactly is the Yen Carry Trade and why should you care?

The Yen carry trade is a strategy institutions use to make money that’s been important in world markets for some time now. The way it works is pretty straightforward.

Investors borrow money in Japanese Yen (JPY). They borrow in Yen because the interest rates in Japan have been low. But how low is low? 

Short-term interest rates in Japan have averaged around near zero to zero percent over the past thirty years. This meant that investors were able to borrow money at extremely low rates, such as 1.0%.

There are a few reasons why Japan’s Interest rates have been so low for decades, such as deflationary pressures, the Bank of Japan’s ultra-low interest rate policies to combat deflation, and a slow economic recovery, just to name a few.

After investors borrow in Japanese Yen (JPY) at around 1.0% or less in interest, they would then use that money to convert it to another currency, such as U.S. Dollars (USD). 

Over the years, the Yen has been in a long term decline against the US Dollar. This has worked out great for investors borrowing in Yen because it takes fewer Dollars to then repay their loans in Yen.

They then take their USD and buy assets that yield higher than 0%, such as US Treasury bonds or stocks. These institutions could make money on the spread between U.S. interest rates and Japan’s interest rates. This is also called interest rate arbitrage.

Here’s a simple example of how the Yen carry trade works.

A 4% return may not sound like much, but after applying leverage (borrowing), institutions can build up massive positions, which can translate to large profits in dollar amount terms.

Even if the assets they purchased didn’t go up, as long as the Yen fell against the Dollar, this trade would still make money when they converted their Dollars back to Yen. This is because they’d have extra dollars compared to the amount of Dollars they had when they initially converted their Yen to Dollars.

A simple way to think of it is this: imagine you could borrow $100 from your parents at 1% interest, then lend it to your friend who pays you 5% interest. This spread of $4 in interest rate is how much money you’d make on the difference.

This Yen carry trade strategy played out on a large scale by institutions and hedge funds over the years. 

When these institutions borrow a large amount of Yen and invest it in other assets, it increases demand and pushes up the prices of assets such as bonds, stocks, and even real estate.

The strategy was hugely popular among institutional investors for many years because it was essentially known as a “risk-free trade.” This was as long as the key factors of low interest rates in Japan, a falling Yen, and US Treasury yields above Japanese interest rates stayed in place. 

How the Yen Carry Trade Can Go Wrong

One of the biggest risks in the Yen carry trade is currency fluctuation. If the Yen appreciates against the currency in which the investments were made, the cost of repaying the borrowed Yen increases.

The profitability of the Yen carry trade also relies on the interest rate differential between Japan and other countries. If the Bank of Japan raises interest rates, the cost of borrowing Yen increases, which reduces profit margins of those institutions.

For example, if a hedge fund borrows 10 million Yen and converts it to US dollars at an exchange rate of 155 Yen per dollar, it would get around $64,516 to invest. 

But if the Yen strengthens and the exchange rate moves to 145 Yen per dollar, it would need $68,965 to repay the 10 million Yen, which translates to a loss of $4,449.

This scenario also played out during the 2008 financial crisis when the Yen appreciated sharply when investors unwound their carry trades, which led to large losses for traders and investors.

More recently, institutions have been using the Yen carry trade to not only buy Treasury bonds, but also US tech stocks, including the “Magnificent 7” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla).

On top of this, many Yen carry trades are done using leverage. Leverage allowed institutions to significantly increase their investment size. For example, if an institution had $1 million in capital, it might borrow 10 times that amount in Yen, converting it to $10 million for investment.

The Unwinding of the Yen Carry Trade

If you followed the global markets in early August, you’d have seen how the Yen carry trade can unwind quickly. This unwinding was mainly triggered by the Bank of Japan’s decision to raise interest rates to 0.25% for the first time in 17 years.

This move was unexpected and led to a spike in the yen’s value, appreciating over 11% against the dollar. What happens when a country raises its interest rates? Their currency typically becomes stronger. 

But as Japanese interest rates increased, the cost of borrowing in the Yen also rose. This appreciation in the Yen made it more expensive for investors to repay their loans in Yen, forcing them to sell off foreign assets to cover debts.

As the Yen appreciated and borrowing costs rose, investors who had borrowed Yen to invest in higher yielding assets faced margin calls. This forced them to sell their investments, which then led to more selling across global markets. This change triggered a series of events:

• The Nikkei 225 stock index dropped 5.8% on August 2 and then dropped another 12.4% on August 5. 
• As the Yen strengthened, the cost of repaying Yen-denominated loans in dollar terms increased.
• The currency movement likely triggered margin calls for leveraged investors.
• To meet these margin calls, institutions had to sell their assets, including U.S. tech stocks. This put selling pressure on the overall US stock markets.
• The Dow Jones Industrial Average fell 500 points, the S&P 500 dropped by 1.4%, and the Nasdaq Composite dropped by 2.3% in early August. 

Meanwhile, over the past few months, US markets began anticipating that the Federal Reserve will be cutting interest rates soon. What happens when a country cuts its interest rates? It typically gets weaker.

With new concerns about a slowing US economy, along with the unwinding of the Yen carry trade, institutions and investors started selling stocks. 

When investors borrowed Yen at low interest rates to invest in higher yielding assets, the strategy worked great – as long as the Yen remained stable or depreciated. 

All of this selling led to a spike in volatility and the VIX (CBOE Volatility Index). As market uncertainty and selling pressure increased, the VIX, which measures the implied volatility of S&P 500 options shot up. 

The VIX cash market rose 181 points on Monday, its largest single-day spike on record.

Why Should Investors Care?

Over the decades, the Yen carry trade has played a major role in driving up global liquidity in markets. 

As a retail investor, changes in the Yen carry trade can affect the volatility and returns on your investments, especially if you have exposure to international markets whether it’s foreign stocks or stock funds you hold. 

For example, let’s look at the iShares MSCI Japan  Exchange-Traded Fund (EWJ). EWJ tracks the MSCI Japan Index, so when the Nikkei drops, EWJ typically follows. 

On August 1, EWJ closed at $67.55. After the two big drops in the Nikkei 225 stock index, EWJ’s closing price on August 5 was 63.43 – a drop of $4.12 in only two trading days. EWJ’s trading volume on August 5 was more than three times its average trading volume.

Final Thoughts

As a retail investor, pay attention to your exposure to investments in foreign assets. As we’ve seen, a stronger Yen can reduce the value of investments denominated in other currencies.

The best way to manage your risk from a Yen carry trade unwind is by diversifying your investment portfolio. You can do this by spreading your investments across different asset classes and geographical regions. 

And avoid using margin!