Tokyo Drift: How the Yen Carry Trade Is Impacting Global Markets

As Americans, we tend not to think too much about currency markets. We enjoy the privilege of having the world's reserve currency, and most global trade is priced in US dollars, so currency fluctuations don't affect our day-to-day lives unless we travel abroad. However, currency markets are huge and liquid, with about $7.5 trillion traded daily compared to around $2 trillion globally for all stocks. Currencies can also have significant impacts on stocks and bonds: a depreciating currency tends to benefit local stocks since it makes exports more competitive (think Japanese stocks), but if a currency depreciates too fast, it can also send local interest rates soaring and cause economic collapse (as seen historically in Latin America).

Like any market, currency rates are fundamentally driven by supply and demand—trade balances and long and short-term capital flows. They also permit enormous leverage. One of the major factors that incentivizes capital flows across borders is the different level of interest rates between two currencies. If interest rates are 0.25% in Japan, but 5.5% in the US, then speculators are drawn to borrow cheaply in Japanese Yen (JPY) at 0.25% and buy and hold US dollars at 5.5% to pick up the "carry" difference of 5.25%. If many people engage in this trade, it can cause large, extended moves in exchange rates.

This is what has been happening for some time to the Japanese Yen. Traders, sometimes using enormous leverage, have been selling Japanese Yen or borrowing in Yen at low interest rates to buy other higher-yielding currencies like the US and Australian dollar.

Below is a chart of the difference between US and Japanese short-term interest rates.

The consequences of this have been a large and historic depreciation in the Japanese Yen, as shown below.

While this depreciation has been a negative for Japanese people who want to travel abroad, for Japan as a whole, it has also been a net positive. Japan is a huge net exporter of goods to the rest of the world, and their stocks benefit from a currency decline. Their equity market has soared and, until recently, became one of the best-performing markets in the world after decades in the doldrums, as you can see below.

Unfortunately, carry trades also have a long and storied history of becoming popular but eventually "crowded" and blowing up when everyone tries to exit at the same time. If you are Japanese and you borrow at home at 0.25% and then put your borrowed money in T-bills at 5.25%, you pick up 5% "carry" over the course of a year. However, if the Japanese Yen appreciates a mere 6% against the US dollar, all your gains have been erased and you are down 1%. As you can see in the next chart, over the last month, any "carry" gains from interest rate differences across borders have been completely wiped out.

This unwinding of the carry trade had knock-on effects globally as Japanese stocks tumbled in line with US stocks and other risk-on assets. To be clear, we believe the unwinding of the Yen carry trades was a contributing factor to the recent global equity sell-off, but not the only driver.

What will happen to the Yen from here is unknown. The Japanese Central Bank as well as the government are happy to see their currency depreciate to some extent because it is a boon to asset prices and their economy. For all the people that were forced out of the Japanese Yen by margin calls and are still nursing their wounds, the reality is that the incentives to put on this trade remain in place; that is, Japan still has much lower interest rates than other developed currencies. Yes, the Bank of Japan recently raised rates, but they remain low.

The linkage between the speculative bubble in the Yen carry trade and the current global equity bull market is tenuous, more coincidence than causation. That said, when panic sets in and everyone is forced to sell, you tend to see markets that didn't appear connected suddenly all falling at the same time. This happened on August 5th: cross-market contagion spread across stocks and currencies as people in different markets sold in panic. We can also guarantee this rush for the exits across many markets will happen again in the future, though we have no idea when, or whether it will involve the Japanese Yen.

Data Source: Bloomberg

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