The yen’s recovery has forced speculators to unwind potentially trillions of dollars in carry trades, a global unwinding that analysts say threatens to further destabilize markets.

Carry trades, in which investors borrow in a country with low interest rates and then invest the money in assets elsewhere to earn higher returns, have surged in the past three years because of ultra-low interest rates in Japan.

However, a stronger yen following last week’s Bank of Japan rate hike has thrown global markets into turmoil as hedge funds and other investors quickly unwind carry trades and sell assets they bought with yen borrowing.

“You can’t unwind the world’s largest carry trade without causing some pain,” said Kit Juckes, a currency strategist at Societe Generale, referring to the global search for its next victim in bond, stock and alternative asset markets.

The yen carry trade has grown into one of the largest ever, by some estimates, as investors in recent years have used the cheap yen to pile into everything from emerging market currencies such as the Mexican peso to Taiwanese stocks, real estate and U.S. technology shares.

Analysts say the size of the trade is hard to estimate because of its sheer size and because it is used by everyone from hedge funds, family offices and private equity to Japanese companies.

While some of the trade involves hedge funds and other short-term investors betting against the yen, years of ultra-low interest rates in Japan have also lured Japanese households, pension funds, companies and banks to look overseas for higher yields in the form of carry trades.

In a call with clients this week, UBS global strategist James Malcolm estimated that the yen carry trade built up since 2011 is about $500 billion, with about half of that growth occurring in the past two to three years.

He said investors have liquidated about $200 billion of positions in the past few weeks, about three-quarters of the positions he ultimately expects to be liquidated.

“There has been a lot of irrational use of carry trades in recent years, so a large-scale liquidation at some stage is inevitable,” a senior Japanese official said.

Cross-border yen borrowing (not all of it carry trades) has risen by $742 billion since the end of 2021, according to the Bank for International Settlements. Cross-border lending originating in Japan reached 157 trillion yen ($1 trillion) by March 2024, up 21% from 2021, according to analysts at ING.

However, the situation has changed radically recently when the Bank of Japan suddenly raised interest rates last week and strongly hinted at further tightening after Japanese authorities intervened in the currency market to support the yen.

Some analysts and traders suspect that most of the speculative positions in the carry trade have now been liquidated. Others believe that more liquidations may be coming as the selling shifts from hedge funds to non-bank investors around the world - so-called real money investors.

“The reality about the yen carry trade is that no one knows exactly how big it is or how much has been unwound now,” said Benjamin Shatil, a currency strategist at JPMorgan in Tokyo. “But there is certainly a sense at this stage that some of the most volatile yen shorts that funded the speculative trade have been completely wiped out.” He said the cash-based yen carry trade may now have pared back from its extremes, “but there is still some way to go”.

In a note to investors after the Bank of Japan's surprise rate hike, Citigroup currency analyst Osamu Takashima said he believes the yen carry trade positions that have accumulated over the past few years are quite large, not only by leveraged investors but also by long-term investors and corporates.

He predicted that "the current adjustment is just the beginning" and estimated that the yen could reach 129 per dollar in 2026 and 116 the following year.

“Estimates of the size of the yen carry trade vary, but most put it in the trillions of dollars,” said Nicholas Smith, chief Japan strategist at CLSA Securities.

Shorting the yen and going long on tech stocks are two of the world’s biggest, most popular (and therefore most crowded) trades in recent years. “Year-to-date, the yen has been statistically more correlated to the Philadelphia Semiconductor Index than to Japan’s benchmark Topix,” Smith noted.

The article is forwarded from: Jinshi Data