Yen carry trade: All about the move that had markets across the globe running helter skelter

The recent global market turmoil is not just a reaction to weaker-than-expected U.S. jobs data but largely due to the unwinding of yen carry trades. These trades, which involve borrowing yen at low interest rates to invest in higher-yielding assets, have been disrupted by the Bank of Japan’s surprise rate hike, causing the yen to appreciate sharply and forcing investors to unwind their positions.

A carry trade is a popular investment strategy where investors borrow money in a currency with low interest rates and invest in assets denominated in a currency with higher interest rates. The aim is to profit from the interest rate differential. The Japanese yen has been a preferred currency for carry trades due to Japan’s long-term low-interest rate policy.

The Bank of Japan’s recent decision to raise interest rates to 0.25% and reduce bond purchases caused the yen to surge over 11% against the dollar. This unexpected move led to a rapid unwinding of yen carry trades as investors sought to avoid losses from a strengthening yen.

In 2008, the unwinding of carry trades was a significant factor in the global financial crisis. The USD/JPY fell nearly 30%, leading to massive liquidations and market chaos. This year, the situation is similar, with the USD/JPY dropping 12.5% in just a month. However, today’s environment benefits from more active central bank interventions, potentially mitigating the impact.

The effects of the yen carry trade unwinding are also felt in India. Japanese foreign portfolio investors hold significant investments in Indian equities. A stronger yen could impact Indian companies with yen-denominated loans, posing risks to their financial stability. According to NSDL data, Japanese FPIs held ₹2.05 lakh crore in Indian equities as of June 30.

The ripple effects of the carry trade unwinding have been severe, particularly in U.S. tech stocks, which have seen significant declines. The Nasdaq dropped over 8% in August, reflecting the broad impact of these market adjustments. Analysts like Tim Graf and Kit Juckes highlight that the unwinding of these massive carry trades cannot occur without causing substantial market disruptions.

The unwinding of yen carry trades has led to significant market volatility, reminiscent of the 2008 crisis but with different nuances. While the 2008 unwinding was dramatic and anticipated, the current situation is marked by heightened uncertainty and geopolitical tensions.