Yen surge sparks chaos as traders sell assets to pay back loans
Brief global crash shows risks of Japan's low-rate policy
The yen carry crisis unfolded so quickly and collapsed so quickly that it exposed how vulnerable the market was to a strategy that hedge funds used to place hundreds of billions of dollars in bets in nearly every corner of the world. The crash looks more like a brief jolt, a momentary panic caused by a small policy shift by the Bank of Japan and renewed fears of a U.S. recession.
The yen carry trade, as it’s known, was once an easy way to make money: Simply borrow from Japan, the world’s last safe haven with the lowest interest rates, and put the money into Mexican bonds yielding more than 10%, Nvidia shares surging, or even Bitcoin. When the yen keeps falling, the loans become cheaper to repay, and the gains become bigger.
Overnight, investors suddenly sold off those trades, which in turn fueled a sharp rally in the yen, with traders selling assets to meet margin calls, leading to a rapid outflow of funds from stocks and other currencies. It also roiled Japanese stocks, triggering the worst one-day sell-off since 1987 on fears that a surge in the yen would hit exporters.
“The yen carry trade remains at the heart of everything going on in the market right now,” said David Lutz, director of ETFs at JonesTrading.
Market stress has been building for weeks as carry trades falter, the Nasdaq 100 retreats from record highs and investor concerns grow that the Federal Reserve will keep monetary policy too tight for too long.
The trigger for the yen carry crisis was a rise in Japanese interest rates. The Bank of Japan’s benchmark rate is currently just 0.25%, the lowest among industrialized countries, but the increase late last month was large enough to force investors to reconsider their long-held belief that Japan’s borrowing costs will remain near zero forever.
Even as markets have stabilized, the episode has raised alarm about how much leverage the Bank of Japan has built up as it continues to pump cash amid soaring post-pandemic inflation. That has left anxious traders trying to gauge whether much of the unwinding has been completed — or whether it will continue to weigh on markets in the weeks ahead.
Giving an answer is tricky because there are no official estimates of how much money is involved in the carry trade. Assuming all of Japan’s overseas borrowing since the end of 2022 was used to finance its overseas purchases and that domestic investors used leverage for their overseas purchases, about $1.1 trillion is invested in the strategy, according to GlobalData TS Lombard.
After last week’s sharp unwinding, strategists at JPMorgan Chase & Co. estimate that three-quarters of the world’s currency carry trades are now unwound, while strategists at Citigroup Inc. say current positioning levels have taken the market out of the “danger zone.”
But others, such as Bank of New York, see further room for unwinding, which could push the yen to 100 per dollar - a level more than 30% lower than where it was at the end of last week.
“Further unwinding of the carry trade appears likely, but the worst and most damaging phase of this bust is now behind us,” Steven Barrow, head of G10 strategy at Standard Bank in London, said in a note to clients last week.
Bloomberg strategists said:
“The fact is that the yen is still significantly undervalued and the remaining carry trade is looking increasingly shaky as the Fed starts to ease policy. But last Monday’s event was all about the markets and it will not have a negative feedback loop on the real economy.”
-- Ven Ram, Macro Strategist
The bubble, as Barrow calls it, has decades-old roots. In the 1990s, as Japan’s economy reeled from a real estate crash, policymakers slashed interest rates to zero. Economists at the International Monetary Fund even blamed the trade for the 2008 financial crisis.
Despite this, by 2016 the Bank of Japan had pushed interest rates into negative territory.
Speculators’ incentive to borrow in Japan has grown as other central banks race to stem a sharp rise in inflation as the global economy recovers from the pandemic. The Bank of Japan has kept its benchmark rate below zero as global interest rates rise, widening the profit margins of carry trades.
As a result, a large amount of speculative funds flowed out of Japan, and traders sold the yen and bought the currencies of the countries where they invested, putting downward pressure on the yen.
The effect is particularly pronounced in Latin America, where interest rates are much higher than in the U.S. and Europe. In 2022 and 2023, currencies such as the Brazilian real and Mexican peso have surged to become some of the world’s best-performing currencies.
For example, borrowing in yen and investing in Mexico generated a 40% return last year alone. The strategy has continued to accumulate gains this year, with a basket of eight emerging market currencies traded in yen returning just over 17% as of early July.
“Being long the peso was clearly a smart move a few months ago — but those days are clearly over,” said Alejandro Cuadrado, head of global FX and Latin America strategy at Bilbao Vizcaya Argentine Bank in New York.
When the yen began to rebound sharply from its lowest level in decades, it created a feedback loop in which traders began to unwind carry trades to lock in gains—and as investors bought yen to repay loans, that pushed the yen higher still. 7 The yen’s gains accelerated after the Bank of Japan raised interest rates for the second time this year on July 31, while unexpectedly weak U.S. jobs data heightened concerns that the Fed might wait too long to pivot.
On August 5, as Japanese stocks were hit by liquidation, with the Nikkei index falling 12%, Bank of Japan Deputy Governor Shinichi Uchida stepped in to reassure investors that the central bank would not raise interest rates as long as the market was unstable. The market then stabilized, with signs that hedge funds pulled back some of their bets that the yen would continue to rise.
The recent shift may have at least temporarily dampened carry trades, with traders expecting volatility in foreign exchange markets to increase this year.
“No trading strategy lasts forever — and the facts have changed,” said Jack McIntyre, senior portfolio manager at Brandywine Global Investment Management. “The Bank of Japan tightened policy, and something changed — in this case, it was the carry trade that broke down.”
