Why the Yen Carry Trade Could Rattle U.S. Markets

After spending much of this year under pressure, the yen rallied sharply in recent days. A number of catalysts kicked off the move.

Expectations that the Bank of Japan (BoJ) will raise interest rates have played a major role. So too has recent currency intervention by Japan’s Ministry of Finance – involving the sale of U.S. dollars and the purchase of yen.

Plus, there’s the unwinding of crowded short-yen positions and speculation that Japanese investors could bring money home from overseas holdings.

On the surface, all this might seem relevant only to currency traders. But beneath it sits one of the biggest dynamics in global markets – the yen carry trade.

How the Yen Became the World’s Cheap Money

A “carry trade” involves borrowing money in a currency with low interest rates and investing it in another currency with a higher return.

For years, Japan’s extremely low rates made the yen an attractive funding source. Investors could borrow cheaply in yen and put that money into U.S. stocks, bonds, cryptocurrencies, or higher-yielding currencies.

The strategy offered good sources of profit.

Investors could pocket the difference between their low Japanese borrowing costs and the higher return on the asset they’d purchased. If the yen continued to weaken, their loan in yen became even cheaper to repay. When both sides worked, it almost felt like free money.

But carry trades rely on important relationships remaining favorable…

If longer-term Treasury yields fall – as they did after the U.S. Treasury announced it would double the size of longer-dated bond buybacks – investing that money in the U.S. becomes less attractive. (Recall that rising bond prices equate to lower yields.)

Yet there’s another major consideration. A strengthening yen increases the cost of repaying the original loan. So any narrowing of the gap between Japanese borrowing costs and the returns available in the U.S. has a direct effect on the carry trade.

By extension, that influences the size of global money flowing into U.S. assets and markets.

When the Trade Unwinds

That doesn’t mean the whole yen carry trade will suddenly be unwound. A Federal Reserve rate hike next week could push U.S. yields and the dollar higher, widening the rate gap again and restoring some of the trade’s appeal.

However, the Fed isn’t the only central bank meeting next week.

The BoJ is also meeting and is expected to raise rates. That means the future of the carry trade will depend on the relative rate paths in both countries – not one rate decision in isolation.

Currency direction and volatility will now also matter just as much. If the yen continues to strengthen, investors could find that the rising cost of repaying their loans outweighs the additional return earned on U.S. investments.

That could force them to sell stocks, bonds, cryptos, or other assets and buy yen to close out their positions.

That additional buying could push the yen even higher, forcing even more investors to unwind, creating a self-reinforcing feedback loop.

To be clear, that doesn’t guarantee a major selloff. But you can see how the unwinding of one corner of the financial system can quickly spill into other markets.

That’s why traders need to watch more than the asset they’re trading.

Sometimes a major catalyst for the next major move is hiding beneath the market. In this case, we could be about to see the unwinding of the cheap yen funding that helped underpin such a substantial part of the asset boom.

I’ve been predicting a return to volatility in the coming months, and this may be one more factor that puts us on that path…

Regards,

Larry Benedict
Editor, Trading With Larry Benedict