The beginning of August 2024 saw the biggest Japanese Stock Market draw-down seen in decades. To blame: the famous Yen Carry Trade.
To give readers an insight into this phenomenon, this article will attempt to explain why the Yen Carry Trade has become a dangerous beast for world financial markets.
Leverage is a double-edged sword. Used to fund asset purchases, it can accelerate the profit potential of an investment if the underlying asset rises more than the cost of the leverage to acquire it. Conversely, leverage will accelerate losses when the same asset price moves on the way down.
The Yen Carry Trade is a leverage trade on steroids. With interest rates at zero in Japan, this trade has been used as a funding tool to acquire assets across the world. The same principle applies if the investment rises, in value or in return, more than the funding cost of the leverage, the investor is on a winner. With a small twist on top. If the value of the Yen falls on currency markets and the carry trade is used to fund a non-Japanese asset, then the investor will also make a profit on the currency movement on top of the gain on the asset price.
‘Here is the Rub’.
Recent falls in the Yen on currency markets, which had been fueling even more of this Yen Carry Trade, forced the hand of the Bank of Japan to do something to redress its interest rate differential with other main currencies such as the US Dollar. By adjusting its monetary policy through reduced Quantitative Easing, as well as higher interest rates, the cost of leverage rose dramatically. In addition, the Japanese monetary authorities intervened to redress the fall of the Yen thereby making their currency more expensive on Foreign Exchange markets.
Some of ‘leveraged Yen Carry Trade’ investors were caught out by the rising cost of borrowing Yen.. With a backdrop of thin summer trading, larger hands, unable to extract themselves from existing leveraged positions put on weeks or months before, were ‘squeezed’ by this new monetary paradigm. A recipe for disaster for them. These same investors were then forced to sell whatever they could to cover their growing daily margin call liability.
Naturally as the authorities did not see this coming, they reacted after the fact by putting on hold any new rate interest hike and stabilizing the currency on the FX markets.
What can one learn from these summertime Yen Carry Trade blues?
In an increasingly financialized world, leverage in all shapes and sizes has been allowed to grow to gigantic proportions. Funnily enough, it is the large private Japanese banks themselves who have been the greatest facilitators of the Yen Carry Trade, without the proper oversight from their own local authorities. A natural kick back for maintaining interest rates so low for so long. As a reminder, loan interest is one of the main components of a private bank’s profit margin. Therefore, a zero-rate policy needs to be compensated somehow to sustain the local private Japanese banking sector.
The Yen Carry Trade has fueled capital flows and asset inflation around world financial markets. Therefore, what happens in Japan now no longer stays in Japan.
The Yen Carry Trade has become a massive ‘off balance’ liability for many institutions. Based on the size of some the trades put on, the world of finance is now fragile to major asset price volatility.
Some would say, leverage in general and the Yen Carry Trade in particular has made Central Banks eat out the hand of large private financial players, as these authorities desperately try to avoid disorderly market situations that they would be unable to contain. The most probable short-term outcome of August 2024 will be more of the same, with the Yen Carry Trade encouraged to go on.
