The trade that triggered the global financial panic on August 5 is alive and well, and it could soon come back to haunt markets.
That’s according to a Tuesday report from the Bank for International Settlements, an influential consortium of the world’s central banks.
But how large is the yen carry trade? It’s hard to say — and it depends on what you are taking into account.
Yen carry trade
Investors take advantage of Japan’s low interest rates to borrow yen and buy high-performing US equities and bonds — a strategy called the “carry trade.”
The Bank of Japan threatened to make the trade unprofitable when it raised Japanese interest rates to combat inflation. The August 5 crash was caused by investors selling their US assets to pay interest on their borrowed yen.
On that day, Japan’s Nikkei and Topix — the country’s two biggest stock market indexes — closed down more than 12%, marking their worst day since 1987. The S&P 500 and Nasdaq, meanwhile, dropped 4.2% and 6.3%.
Responding to the panic, the BoJ said it wouldn’t raise rates anymore than it already has, and markets calmed down.
But the Federal Reserve, by announcing that rate cuts were soon coming to the US, may just reignite the crisis, since the move will narrow the dollar-yen interest differential just as surely as an increase in Japanese rates would.
That wouldn’t be good for crypto: Bitcoin and Ethereum plunged 15% and 20%, respectively, on August 5, and could react much the same way if the yen carry trade were to unwind violently again.
BIS’ $764 billion estimate
Estimating the size of the yen carry trade is no small feat — even the BIS has trouble with it.
The problem stems from the array of ways traders can implement the trade. For example, entities located outside Japan can borrow yen from Japanese banks to then invest these funds. Or foreign exchange traders can simply short the yen using derivatives.
Yen-denominated loans to nonbanks outside Japan stood at around $250 billion in March, the BIS said. Cross-border debt instruments issued by nonbanks in offshore centres bring that figure up to roughly $500 billion, per the consortium’s estimate.
In addition, funds channelled by foreign banks in Japan back to their headquarters overseas are worth about $90 billion.
Hedge funds, meanwhile, may have deployed as much $160 billion in over-the-counter yen derivatives, the BIS said. And net short positions in yen futures peaked at around $14 billion, though that trade unwound completely on August 5, the report said.
So far, that brings the yen carry trade to roughly $764 billion — at least before the crisis — yet that figure is likely to be a significant underestimate because large gaps in the data remain, according to the BIS.
The number doesn’t take into account, for example, various methods to implement currency trades using off-balance sheet derivatives.
Nor does it include the unwinding of retail traders’ positions via margin brokerage platforms, which notably impacted Bitcoin and Ethereum, the offshore Chinese renminbi, the Malaysian ringgit, the Mexican peso, the Brazilian real, and the South African rand.
JPMorgan and Arthur Hayes
Analysts at financial giant JPMorgan Chase have taken a more conservative approach to calculating the yen carry trade.
Taking only spot currency trades into account, the investment firm said in an August 7 report that 75% of the trades had been removed from the market during the crisis.
While JPMorgan did not give an estimate for the scale of the strategy, its narrower definition of the yen carry trade — and its assertion that it was now mostly unwound — provides a perspective that differs markedly from the BIS calculations.
On the more extreme side of the equation, BitMEX co-founder Arthur Hayes has said that Japan is running $24 trillion worth of risk on the yen carry trade.
Citing numbers taken from a Deutsche Bank report, Hayes said the Japanese government’s balance sheet is worth six times the country’s gross domestic product.
That includes Japan’s $15 trillion in liabilities, which it uses to borrow yen and fund the carry trade, and $9 trillion in assets. Of these assets, roughly $2 trillion is directly invested in foreign securities.
But domestic loans, securities, and equities — the majority of the government’s remaining assets — also perform well in a low interest rate environment, Hayes said. And they benefit from the yen depreciating.
It’s all relative
Estimating the size of the yen carry trade, then, depends on what is being counted and who is doing the counting.
While JPMorgan analysts reduced the scope of their study to spot currency trades, the BIS looks at foreign borrowing and derivatives trading in its various forms.
Meanwhile, crypto’s foremost macro expert, Arthur Hayes, uses Deutsche Bank to take a more holistic approach by examining how the Japanese government funds itself while continuously depreciating its currency.
Tom Carreras writes about markets for DL News. Got a tip about the yen carry trade? Reach out at tcarreras@dlnews.com