When Will the Yen Carry Trade Break?

Decades of negative interest rate policy in Japan have ended. That could mean the end of the $20 trillion “yen carry trade,” once one of the most popular trades on foreign exchange markets, and a chain reaction in the global economy. The yen carry trade is when investors borrow yen to buy assets denominated in higher-yielding foreign currencies, like the USD, where interest rates are higher.

Even now that the BoJ is hiking rates, interest rates in Japan are still low, and will remain as such — the economy can’t handle too high of an uptick too fast after becoming dependent on NIRP. But the moment rates were raised above zero, the yen carry trade instantly became a far riskier gamble. The yen has recently weakened against the dollar, keeping the carry trade attractive for now. But if the BoJ starts dumping US Treasurys, sending yields up, and sacrificing stocks, a vicious cycle begins where the dollar strengthens against the yen to the point of the yen becoming practically worthless.

USD vs Yen, March 18 – April 17

Source: tradingview.com

Of course, it’s all relative. The yen is weak against the dollar, but with rampant inflation, the dollar is losing value too — just not as fast. When the media tells you the dollar is currently strong, what they’re really saying is that it’s strong compared to even weaker currencies. As Peter Schiff said on his podcast earlier this week:

“Part of what’s masking this problem is the relative strength of the dollar. And I say ‘relative’ because the dollar is actually weak. Gold tells you what’s actually happening: gold today hit a new all-time record high in every single currency…gold tells you the dollar is down. What the rising dollar index tells you in an environment of a rising gold price is that the dollar is losing value.”

As it is, foreign exchange markets make traders money without adding any real value. With a global monetary standard where each country’s currency is pegged to the price of gold, there wouldn’t be the same opportunity to trade on the short-term fluctuations across different currencies, the supply and borrowing cost of each one determined by a central authority. Foreign exchange markets could still exist, but their appeal would be drastically diminished.

Since they essentially allow traders to harvest profits without investing in or creating anything of actual material value, one is left wondering if all that capital would end up flowing into more productive ventures. Carry trades also rely on leveraged bets, which when they blow up, blow up hard.

Speaking of blowing up, the conflict in the Middle East just keeps getting worse, with a standoff between Iran and Israel threatening to go nuclear (perhaps literally) and drag in more foreign intervention. If oil spikes too hard against the yen, and the BoJ panics to save it, it could lead to a global margin call that begins a domino effect of imploding stock prices and a widespread economic collapse.

The BoJ has to let bond yields rise to counteract the weakening yen, bringing investors back to buying Japanese debt and pushing up bond yields in the US and EU. That means higher interest payments in the US and EU in the short term, which can only be paid with more borrowed money, creating a vicious feedback loop that stands to reveal the fundamental insolvency of major national economies.

Decade-long highs for Japanese Bond Yields 🇯🇵 pic.twitter.com/vkzdr1iThH

— Koyfin (@KoyfinCharts) April 16, 2024

Every action has an equal and opposite reaction — but when you’re leveraged to the gills, that reaction isn’t equal, it’s drastically magnified. Enough traders overcompensating at once can have disastrous effects in any market, but even more so when they’re trading with massive leverage.

With rate cuts still on the table (for now) in the US this year, the viability of the yen carry trade will be further eroded, narrowing the gap between interest rates on the two currencies. The yen is becoming more volatile, and choppy Forex markets make carry trades risky since they rely on a predictable gap on the value and cost of borrowing between currencies. And if the yen carry trade fully unwinds, the blow-up could be spectacular enough to take other parts of the economy out with it.