What is carry trade? Yen carry trade explained & its impact

As markets tumbled on August 5, many asked: what is carry trade? Discover how this financial strategy quietly fueled the chaos, leading to staggering losses globally.

August 5, 2023, will go down as one of the most volatile days in recent financial history. It was a day when the markets shook, and investors held their breath as billions of dollars were wiped out in mere hours. 

Dubbed ‘Crypto Black Monday,’ the crypto market saw a massive sell-off, with the total market cap plunging from $2.16 trillion on August 4 to a staggering low of $1.78 on August 5, a decline of nearly 18%. 

But the shockwaves weren’t confined to the crypto world. Major global stock indices, like the NASDAQ100 in the U.S., FTSE100 in the UK, and India’s NIFTY50, experienced sharp declines that left investors reeling. 

Japan’s Nikkei225 bore the brunt, plummeting nearly 12.5% in a single trading session – the steepest fall since 1987. It was a day of red across the boards.

While there were numerous reasons for this market turmoil – from fears of a looming U.S. recession to rising geopolitical tensions in West Asia – one factor stood out among the rest: the unwinding of the yen carry trade. 

This term might sound complex, but it’s crucial to understand the domino effect that led to the global financial tremor.

So, what does carry trade mean, and how does it wield so much power over the markets? Let’s dive into this concept, break it down, and explore how it played a huge role in the market chaos.

What is carry trade?

The term “carry trade” might sound fancy, but it’s actually a pretty simple concept once you break it down. 

Imagine borrowing money at a super low interest rate from one country and then investing that borrowed money in another country where the interest rates are much higher. The goal? To pocket the difference between the low borrowing cost and the higher returns.

Let’s say you borrow Japanese yen, which often has very low interest rates, and use it to invest in U.S. dollars, which typically offers higher interest rates. The profit you make from the difference is what traders refer to as the “carry.”

But here’s the thing: the carry trade isn’t just some random strategy used by a handful of traders. It’s a massive global phenomenon that can involve trillions of dollars moving across borders. In fact, it’s one of the reasons why certain currencies, like the yen, can see huge amounts of trading volume on a daily basis.

Carry trades can have a big impact on global financial markets. When they’re popular, they can drive up the value of currencies that offer higher returns. 

But when investors start to unwind their carry trades—meaning they close out these positions—it can lead to sharp movements in the markets, as we saw with the yen recently.

Let’s understand it with some examples.

Examples of a carry trade

• Borrowing yen at 0.1% interest, an investor converts it to Australian dollars to buy bonds offering a 5% yield, aiming to profit from the difference in interest rates.

• Taking out a Swiss franc loan at 0.5%, the investor converts it to Turkish lira and invests in Turkish real estate, benefiting from higher returns but risking currency fluctuations.

• An investor borrows euros at a low rate and invests in Brazilian agriculture stocks, looking to capitalize on Brazil’s strong export growth for higher profits.

• Using a U.S. dollar loan at 2% interest, the investor converts to Indian rupees and buys high-yield Indian corporate bonds, aiming for better returns while managing the risk of currency changes.

• Borrowing British pounds at a low rate, an investor invests in South African mining stocks, hoping to gain from rising commodity prices but staying cautious of the rand’s volatility.

How does a carry trade work?

Now that we know what a carry trade is let’s dive into how it actually works. 

Imagine you’re a trader who has access to borrowing Japanese yen at a super low interest rate, say 0.5%. You borrow 1 million yen and then convert that yen into U.S. dollars. 

The reason you’re converting it is because you know that in the U.S., you can invest that money in bonds that offer an interest rate of 4%. So, you take your converted dollars and buy U.S. bonds.

Here’s where the magic happens. You’re paying just 0.5% interest on the yen you borrowed, but you’re earning 4% on your U.S. bonds. The difference, 3.5%, is your profit – that’s the “carry” in the carry trade.

But it’s not just bonds where traders park this money. Some people use the borrowed funds to invest in stocks, aiming for even higher returns. 

Let’s say you took that same 1 million yen, converted it into U.S. dollars, and bought shares in a company like Apple or Tesla. 

If those stocks rise in value by 10%, you not only earn the profit from the stock increase, but you’re still benefiting from the low interest rate on your original loan.

For example, if Apple shares go up 10%, and you sell your stocks, the profit from the stock gain could be far higher than what you’re paying in interest on the borrowed yen. 

However, if the stock prices drop, or if the yen strengthens against the dollar, your profits can quickly evaporate, or worse, turn into a loss.

Traders all over the world engage in carry trades, not just with yen and dollars, but with all sorts of currencies. For example, borrowing Swiss francs (which also has low-interest rates) and investing in Australian dollars (which typically offers higher interest rates) is another popular carry trade. 

The key is always the same: find a currency to borrow cheaply and another currency to invest in for a higher return.

Carry trades are popular because they can amplify returns when the market is favorable. But they also come with risks. It’s why some say carry trades are like “picking up pennies in front of a steamroller.” The potential for profit is there, but the risks can be just as big.

Impact of Yen carry trade on global markets

The yen carry trade has been a popular strategy for investors for years, thanks to Japan’s extremely low interest rates. The Bank of Japan kept its benchmark interest rates at almost zero percent for a prolonged period, even dipping into negative territory at -0.10% since 2016. 

This policy was designed to stimulate economic activity by making borrowing cheap. However, because Japan is a major global economy, these low rates had far-reaching effects beyond its borders.

Here’s how the Japanese yen carry trade works in this context: Investors borrow yen at these low interest rates and then convert the yen into other currencies to invest in higher-yielding assets abroad. 

For instance, they might invest in bonds, stocks, or real estate in countries like Brazil, Mexico, India, or the U.S., where returns are higher. 

The difference between the low cost of borrowing in Japan and the higher returns on these foreign investments creates profit — a strategy that attracted trillions of dollars over time.

But things changed in 2024. On March 19, the BoJ raised interest rates for the first time since 2007. Then, on July 31, it increased rates again, bringing the benchmark rate up to “around 0.25%” from its previous range of 0% to 0.1%. 

While this might seem like a small change, it was a stark shift for Japan, where rates had been so low for so long.

This rate hike had two immediate effects. First, it made borrowing in yen more expensive, which reduced the profitability of the carry trade. 

Second, it led to the yen strengthening against other currencies, meaning that when investors converted their foreign investments back into yen, they got less value than before.

As a result, many investors began to unwind their carry trades—essentially selling off their foreign assets to repay their yen loans. This mass sell-off triggered a ripple effect across global markets. 

Stocks, bonds, and other assets that had been propped up by yen carry trade investments began to plummet in value. The sudden surge in demand for the yen also caused the currency to appreciate even further, adding to the losses for those still holding foreign assets.

Risk and rewards

Before diving into carry trades, it’s essential to weigh the potential rewards against the inherent risks.

Rewards of carry trades

• Interest rate differentials: The primary reward is the profit from the difference in interest rates between two countries. Borrowing at a low rate and investing at a higher rate allows traders to pocket the difference.
• Potential for high returns: When invested in high-yield assets like stocks, the potential returns can be far higher, amplifying profits beyond just the interest rate spread.
• Leverage: Carry trades often involve borrowing large sums of money, which can magnify profits when the trade works in your favor.
• Steady income stream: When done correctly, carry trades can provide a steady and predictable income stream, especially when interest rates remain stable and favorable.

Risks of carry trades

• Currency fluctuations: A change in the value of the borrowed currency (e.g., yen) can lead to losses when converting back to repay the loan, especially if the borrowed currency strengthens against the invested currency.
• Market volatility: Investments made with borrowed funds, such as stocks or bonds, can decrease in value, potentially leading to losses instead of the expected profits.
• Interest rate changes: If the interest rates in the country where you borrowed money increase, your borrowing costs could rise, reducing or eliminating your profit margin.
• Liquidity risk: In times of market stress, it might be difficult to quickly exit a carry trade without incurring large losses, especially if everyone is trying to do the same thing.

Conclusion

The recent market turmoil, sparked by the unwinding of the yen carry trade, shows just how powerful and risky this strategy can be. 

In the end, carry trades are a balancing act between risk and reward, and understanding both sides of the equation is key to making smart investment decisions.