Aftershocks of Carry Trade Could Still Have Reverberations

Aftershocks of Carry Trade Could Still Have Reverberations

Sub: Eco

Sec: External Sector

• Continued Unwinding Risks:
  • Investors noted that the aftershocks of a massive carry trade impacting global financial markets were not yet over.
  • Further unwinding in the coming days could increase the risk of shakeouts in other assets.
• Triggering Factors:
  • The sell-offs were triggered by a higher-than-expected U.S. unemployment rate on Friday, raising concerns about a potential U.S. recession.
  • The situation was worsened by investors unwinding yen-funded trades used for stock acquisitions after a surprise Bank of Japan rate hike.
• Carry Trade Explanation:
  • The carry trade involves borrowing money from economies with low interest rates (e.g., Japan or Switzerland) to fund investments in higher-yielding assets elsewhere.
• Expected Volatility:
  • Investors anticipate continued volatility and expects the sell-off to continue for a few more days due to the large size of these trades.
  • Investors are still assessing the size of these trades and the extent of the cheap funding deployed in equities.
  • Hedge fund strategies most affected by a yen rally are global macro quantitative and managed futures, as they have short exposure to the Japanese currency.
  • Some money managers had already been reducing risk in the past few days and noted the unwinding of momentum across multiple asset classes.
• Opportunistic Buying:
  • Despite the downturn, some investors are looking to buy at lower valuations.

Understanding the Yen Carry Trade and its impact on Global Markets

Overview: –

The yen carry trade involves borrowing money in Japan, where interest rates are exceptionally low, and investing that money in countries with higher interest rates to earn a profit from the difference. This strategy is commonly used by global investors seeking higher returns.

• Low Interest Rates in Japan:
  • The Bank of Japan (BoJ) maintained interest rates at zero percent between 2011 and 2016 to stimulate the economy.
  • Since 2016, the BoJ even pushed interest rates below zero (-0.10%).
  • This policy created a large supply of cheap money, encouraging investors to borrow in yen and invest in higher-yielding assets elsewhere.
• Global Impact:
  • The yen carry trade became popular because Japan’s low interest rates persisted even when other central banks raised rates following the Russia-Ukraine war.
  • Investors used the borrowed yen to invest in countries like Brazil, Mexico, India, and the US, fueling investments globally.
• Recent Changes in BoJ Policy:
  • Between mid-March and July-end 2024, the BoJ raised interest rates by 35 basis points to 0.25%, marking a significant shift.
  • On July 31st, a further 25 basis point increase was announced, causing a sharp reversal in monetary policy.
• Unwinding of the Yen Carry Trade:
  • The increase in Japanese interest rates led to the strengthening of the yen against the dollar and other currencies.
  • Assets held in currencies like the Brazilian real, Mexican peso, Indian rupee, etc., became less valuable when converted back to yen.
  • The narrowing returns differential and the prospect of further rate increases prompted investors to unwind their yen carry trades, selling off assets bought with cheap yen.
• Market Impact:
  • The unwinding of yen carry trades caused a massive sell-off in global markets on August 5, 2024, leading to one of the sharpest declines in decades.
  • Higher interest rates in Japan made yen investments more attractive, increasing the opportunity cost of continuing with the carry trade.
  • The uncertainty and rapid market changes led to jittery investor sentiment, exacerbating the decline.

The yen carry trade was a popular investment strategy due to Japan’s prolonged low-interest-rate policy. Recent increases in Japanese interest rates triggered the unwinding of these trades, causing a significant sell-off in global markets.