Volatility Incoming: The End of the Yen Carry Trade
Earlier this year, we discussed the likelihood of the yen carry trade unwinding under the BoJ’s decision to end decades of zero-interest rate policy, or ZIRP. That unwinding now appears to be entering full swing.
The trade is based on borrowing yen to buy assets denominated in currencies where interest rates are higher, like T-bills and stocks. With rock-bottom interest rates, the yen was practically free to borrow. But with rates in Japan now finally being hiked while other countries are itching to lower them (or already have), the viability of the trade could be coming to an end after being established as one of the most popular plays on foreign exchange markets.
Now that investors’ opportunity for nearly-free borrowing is over, they’re dumping their yen. Further selling portends more volatility on top of the already whipsaw-like action for the currency since the Bank of Japan ended decades of ZIRP, intervening several times to prop it up.
USD vs Yen, 1-Year Chart
The carry trade may continue to some extent for as long as interest rates in the US remain higher than in Japan, but with a rate cut from the Fed looking more and more likely this year, and the hawkish BoJ itching to hike further, the risks of the yen carry trade increase, and it becomes less and less appealing.
Japan remains the outlier in the global rate cut game. Despite high inflation across much of the world, central banks have cut rates to some degree or another in Canada, Switzerland, Sweden, China, Mexico, Brazil, and most recently, the U.K.
After billions in interventions from the BoJ, the yen strengthened 8% against the dollar in recent weeks after hitting the lowest exchange rate in 38 years. Higher interest rates are making yen-denominated investments more attractive. But as the carry trade unwinds, it could be replaced by a “reverse carry trade.”
This is where traders borrow the yen to buy assets denominated in a lower-yielding currency or asset, expecting the yen to weaken later on. Once the yen falls again, they can exchange the lower-yielding assets back into yen at a lower cost than the initial borrowing amount. This way, they can profit from both the interest rate differential and the yen’s decline.
The potential implications for global markets are many. Yen turbulence can spell trouble for leveraged bets, with potential for a wave of margin calls that trigger a broader international sell-off. This is especially true if the yen goes high enough that spikes in prices for essential commodities like oil start to negate the newfound strength of the yen, triggering more interventions from the BoJ and further unwinding. In other words, a doom loop that ripples through global markets.
Japanese stocks have reacted with tremendous volatility, with the Nikkei 225 dropping from last month’s all-time high down to levels last seen in January and Topix, another index, tumbling over 9% in two days.
TOPIX (TOPX) 5-Day Chart
This is the biggest two-day drop since the 2011 tsunami that leveled the Fukushima nuclear plant, signaling domestic uncertainty in the wake of higher interest rates in Japan just as the Fed is mulling a rate cut this coming fall. These factors could lead to further strengthening of the yen versus the US dollar, and a full-blown carry trade unwinding.
And since the yen carry trade has helped fuel bull markets in other countries by providing an opportunity to borrow in a low-interest currency to buy assets elsewhere, stock market volatility could easily creep beyond Japan. The BoJ, stuck between a rock and a very hard place, can’t have its cake and eat it too. It must decide: Does it save the yen, save its stock market, or save its government bonds, roughly half of which it already owns? Stuck in a monetary and economic ouroboros, the BoJ has no good option.
The Fed and other banks are trapped as well, trying to prevent banking and real estate crises by lowering rates despite inflation still running hot. The powder keg is primed, so the only question is who will light the first match.
