The Carry Trade Has Been a Winner. Why the Bank of Japan Is Giving It a Handicap.

In principle, it’s very simple. Borrow money in a country with very low interest rates and then invest it in a country where you can get considerably higher returns. Japan’s central bank interest rate has been around zero since 2016. 

The U.S. 10-year bond yield, by contrast, has been higher than that at least 2% for most of that time–the pandemic was a lengthy exception. 

This is the general idea–borrow money at 0% interest, carry it abroad to invest at 2% interest. The difference is your profit. And it’s a sure winner. Lending to governments is considered risk-free because there’s virtually no chance they won’t repay their debts—they can always make more money.

Take your cash to other places than the U.S. and your profits could be even bigger–for example, Mexico’s 10-year government bond yield is currently just shy of 10%.

Who Does It? 

These trades require a lot of capital and are therefore more difficult for mom-and-pop investors working from their kitchen table. But currency traders at big investment banks have been making a killing on this for years. It got even more popular as the Federal Reserve started raising interest rates aggressively in early 2022 while the Bank of Japan kept rates at rock bottom.

What Could Go Wrong?

While the carry trade seems like a sure thing–and it mostly has been–there are still risks. Changes in interest rates and exchange rates can either reinforce or derail the strategy. For example, the BOJ’s ultra loose policy has driven the yen to 30-year lows against the dollar, which makes the carry trade even more profitable. But if the yen starts to strengthen now, it will cut into carry traders’ earnings.

Rising interest rates tend to strengthen currencies by making investments in those currencies more attractive.

“The yen sold off on the headlines that the BOJ would keep an accommodative policy for a while, but recent headlines are suggesting that further rate hikes may be forthcoming,” said ING strategist Chris Turner.  “The problem for the yen, however, is that volatility remains exceptionally low and the carry trade exceptionally popular.”

Is the Carry Trade Dead?

Probably not–yet. Interest rates in Japan are still much lower than elsewhere and the BOJ has said it will move slowly and cautiously. 

But the decision to raise rates does change the game, especially because the next move in interest rates in the U.S. and Europe is expected to be down. The carry trade will almost certainly become a lot less popular.

Are There Any Winners?

China has a lot to gain if the BOJ continues to raise interest rates, thereby strengthening the yen. China and Japan both rely heavily on exports of things like electronics and cars for economic growth, and a stronger yen compared to the yuan will make Chinese goods more attractively priced.

Write to Brian Swint at brian.swint@barrons.com