The carry carnage: What is the Yen trade that has routed global markets

After almost 17 years of maintaining low interest rates, the Bank of Japan increased overnight call rates from 0-0.1% to 0.25%. This has been a major factor, which has caused a sell-off in the global markets, as the profitability of the carry trade has now come into question.

So, let’s start with the most basic question: what is a carry trade? It is a form of speculative trading strategy that involves borrowing money in a currency with low interest rates and investing it in assets in a currency with higher rates.

What are the key factors that impact this trade?

• Interest rate differential
• Fluctuation in exchange rates

Let’s understand with an example.

A hypothetical carry trade: US dollar (USD) vs Japanese yen (JPY)

Let’s assume you borrow 1,00,000 JPY at 0.1%. Then, you convert the borrowed yen into USD and invest it in a US asset yielding a 5.5% annual return. In this hypothetical scenario, you maintain the investment for a year.

• The cost of borrowing the JPY is 0.1%.
• The return on the US investment is ~5.5% of the invested USD amount.

Let’s look at the table below.

Now, let’s see when the trade unwinds, or the position is closed.

Scenario 1: Base case

Note: This is a simplified example to explain the concept.

What would happen if:

• The Japanese interest rate increases from 0.1% to 0.25%. Let's analyse the impact when the trade unwinds.

Scenario 2: Rate hike

• Yen appreciates/strengthens against the USD. Once again, let's analyse the impact when the trade unwinds.

Scenario 3: JPY appreciation

We hope this explains carry trade to you and helps realise the risks associated with it.

Why does this interest rate hike matter?

• Profitability impact: As highlighted above, this sharp rate hike comes after almost 17 years. This will now hurt profitability, as shown in Scenario 2. While the increase in rate hike may not seem significant, carry traders usually trade in large volumes. Thus, even optically smaller rate hikes will significantly hurt profitability. Besides, these trades are typically very short-term, further magnifying the impact.

• Double whammy: With the increase of the Japanese interest rates, market experts believe this will lead to increased flows in the Japanese markets. This will strengthen the JPY against the USD. Effectively, Scenarios 2 and 3 are playing out simultaneously.

• But wait, it's not over: Recent reports on US inflation and unemployment suggest that the US Fed might have to consider a more aggressive rate cut approach. So, returns earned in the US markets will also diminish and further hurt profitability.

Is this the only reason why the markets are falling?

No. Last week, there have been a few more disappointing updates. Please read the detailed articles below

• Read - Global markets meltdown: From Yen’s surprise to disappointing earnings, all you need to know
• Read - US stock market plunges on weak jobs data, tech-heavy Nasdaq enters correction mode

Some key facts for those interested:

Zero interest rates in Japan : The BOJ implemented a zero-interest rate policy in November 2010. This policy continued until early 2016 when it was further reduced to -0.1%. The central bank maintained this negative rate until March 2024 when it was adjusted to 0.1%. On July 31, 2024, it increased the rate to 0.25%.

Trade size: It is difficult to ascertain the exact size of this trade. That said, certain market experts believe the size of the trade could be as high as $4 trillion.

What does this mean for investors?

This is one of those scenarios where we would wait and watch before we write anything in this section.

Most major global markets are either frothy (valuations are high) or facing some serious challenges. In such a case, could this be the straw that breaks the camel's back or is this just a blip? It is difficult to say at this time.

Given the impact in global markets, it is likely (not necessary) that either of the countries’ governments or central banks could intervene to calm markets.