The yen carry trade explained

It looks like the Bank of Japan (BOJ) is finally ready to raise rates again this month. So, right on cue, out come the doomers to ring the alarm on how the unwinding of the yen carry trade is going to blow up global financial markets.

Should we be worried? How could a potential unwind of this trade affect investors in Japan?

What is the yen carry trade?

The core idea behind this trade is to borrow money in a low-interest currency (JPY) and invest it in higher-yielding assets elsewhere.

For example, a fund could borrow yen at less than 1% interest, invest in US Treasuries earning 3.5%, and pocket the difference. This works perfectly until exchange rates make a big move. Then things can get interesting.

A conservative estimate puts the size of the carry trade at around $1 trillion, based on Japanese banks’ foreign lending. Some estimates use the notional value of FX swaps and forwards using the yen to reach a figure closer to $14 trillion.

Of course, hedge funds are not necessarily just buying conservative US government bonds on this trade. A mountain of cheap yen is converted to dollars and other currencies and flows into all kinds of assets. A deep dive would likely reveal that a large portion of this trade has gone right into the red-hot Magnificent 7 stocks.

Why Japan?

The carry trade can take place using any currency with a low interest rate. Japan has been the primary go-to market due to its unique characteristics:

• The lost decades following the bursting of the bubble in the early 90s
• Deflation and slow growth
• The BOJ’s long-term low/negative interest rate policy
• Hence, the yen became the world’s cheapest funding currency

How the carry trade makes (and loses) money

This trade works based on the interest rate differential – the carry. With a stable or weakening yen, it will remain profitable. In this type of environment, it’s hard to miss.

Problems occur if the yen strengthens. If an institution borrowed yen at ¥150 to the dollar but later the yen strengthens to ¥130, it suddenly requires more dollars to repay the same yen loan.

The unwind then happens as follows:

• Sell the dollar asset (treasuries/stocks, etc.)
• Convert to yen
• Repay the yen loan

This unwind puts downward pressure on the asset being sold, which could be US treasuries or global stocks. And the flood of capital back into JPY accelerates the yen’s strengthening. A relatively small move in exchange rates can snowball into something much larger.

Famous unwind events include the 1998 Asian financial crisis and the 2008 global financial crisis. In 2024, we saw a mini unwind as the BOJ shifted policy.

Why does it matter to everyday investors, especially in Japan?

With the US central bank cutting rates and the BOJ looking to raise rates, there is a real possibility that the yen will strengthen in the short term. Most Japan residents will be relieved as foreign goods and overseas trips will become more affordable.

However, the unwind can suck out global liquidity and do some real short-term damage to our investments. Not many risk assets fare well in this kind of event, so be prepared for international stocks, Japanese stocks, high-yield bonds and crypto to take a beating. Japanese exporters, such as Toyota, are particularly sensitive as a stronger yen erodes their overseas profits.

So, are the doomers right this time?

Beware of people claiming that the yen will suddenly surge and stocks will crash overnight. The reality is:

• Yen carry trade unwinds tend to happen in bursts, and not always in a straight line
• Central banks will often intervene, verbally or via policy tools.
• Markets tend to pre-position before the worst moves happen

You can already see this pre-positioning happening. The yen has strengthened over the last few days after the BOJ hinted at action at its next meeting. Note how BOJ governor Ueda is trying to communicate his thoughts in advance and avoid a “shock rate hike” a la August 2024.

People writing epic threads on X tend to overstate the timeline risks. Sharp moves can indeed happen. However, it doesn’t necessarily guarantee an imminent crash.

Should we be worried?

Concern about the carry trade unwind is most rational if you have:

• Investments heavily exposed to foreign currencies
• A portfolio dominated by global stocks
• Income linked to export-driven Japanese companies

There is less to worry about if you have:

• Mostly yen-denominated assets
• A long time horizon
• No plans to move money internationally soon

Concerns about a carry trade unwind are certainly not irrational. However, the real risk lies less in timing the event and more in understanding how currency moves can affect your portfolio and positioning accordingly.

So it really comes down to portfolio structure. Trying to predict macro events is insanely hard…

Ok, then how do I hedge against this?

Of course, some assets will benefit from a carry trade unwind:

• The yen, of course, is the obvious winner – that trip abroad could get a lot cheaper next year!
• Gold is historically a beneficiary of unwinds as investors deleverage and seek out safe havens. If the yen is rising, the dollar is usually falling, which is generally good for gold.
• Long-duration government bonds generally do well as the world goes risk-off and money flows into the safest assets. Bond prices go up as yields go down.

In conclusion, don’t let the doomers scare you out of long-term investments, but be prepared for some volatility. Keep an eye on central bank rate decisions, the corresponding US-Japan interest rate gap, USD/JPY exchange rate and global risk sentiment.

Personally, I am long-term bearish on the yen, but in the short term, anything can happen.

It’s always good to keep some dry powder to pick up risk assets while investors run scared.

And make sure your passport is still valid for that overseas trip you’ve been planning!

Top image from Freepik

Disclaimer: This should go without saying, but the information contained in this blog is not investment advice, or an incentive to invest, and should not be considered as such. This is for information only.