Yen Carry Trade blowback explained: What investors in India should do now | Personal Finance
What is the Yen Carry Trade
For years, investors have been taking advantage of Japan’s ultra-low interest rates to profit from a strategy known as the “yen carry trade.” This involves borrowing money in yen at a low-interest rate and investing it in assets with higher returns, like bonds or stocks, in other countries. However, this strategy has recently hit a roadblock. Japan’s central bank, the Bank of Japan, surprised markets by raising its interest rate from near-zero to 0.25%. This unexpected move has caused the Japanese yen to strengthen significantly.
As a result, many investors who had borrowed yen to invest in other currencies or assets are now facing losses. This sudden reversal of the yen’s value has led to market volatility and concerns about the potential impact on global financial markets.
Tata Mutual Fund explains this phenomenon in detail and its impact on markets:
The Japanese Yen is usually considered less volatile and a favourite among carry-funding options by global investors given the low cost of borrowing. The traders profit from a divergence in interest rates across the world.
• Japan kept interest rates ultra-low for decades following the implosion of an asset bubble in the 1990s that contributed to persistent deflation.
• It continued holding rates low after the pandemic, in contrast to other major central banks that started hiking them.
• This created a divergence in monetary policy that impacted the Japanese yen, which sank to a near four- decade-low against the strong US dollar last month.
• The divergence helped carry trade that involves borrowing cheaply in yen — on the expectation that the yen will continue to fall — and investing in some high-yielding currency or asset preferably backed by a strong macro argument.
However, this strategy has now been hit with a hitch. The Bank of Japan’s decision to raise its main interest rate to 0.25% marked a departure from its ultra-loose monetary policy. This unexpected move caused a sharp appreciation of the yen, surprising many investors who had bet on its continued decline.
The rapid strengthening of the yen has resulted in substantial losses for those engaged in yen carry trades. As the cost of borrowing in yen has increased, the profitability of these trades has diminished.
Impact on markets:
The rate hike triggered a chain reaction. The Japanese yen, which had been weakening due to the interest rate differential with other major currencies, rapidly strengthened. This sudden appreciation of the yen caught many investors off guard, leading to a massive sell-off of Japanese assets.
The Nikkei 225 index, Japan’s primary stock market benchmark, plummeted by over 12% in a single day, marking its worst decline since the 1987 Black Monday crash. This dramatic fall was primarily driven by the unwinding of yen-carry trades With the yen strengthening, these investors were forced to liquidate their positions, exacerbating the market downturn.
The Reverse carry trade was a major cause of concern for the US too. On Friday, the S&P 500, declined 1.8%. A weakening job market caused fears of recession in the US. The global markets reacted in frenzy as the US equities markets plummeted. Nonfarm payrolls grew by just 114,000 for the month, down from the downwardly revised 179,000 in June and below the Dow Jones estimate for 185,000. The unemployment rate edged higher to 4.3%, its highest since October 2021.
A domino effect swept through Asian equity markets too.
Japan’s Nikkei 225 index took the brunt of the sell-off, plummeting more than 20% from its peak, officially entering a bear market. The turmoil extended to other Asian markets. South Korea’s Kospi and Taiwan’s Weighted Index experienced significant declines, with both indices falling by more than 8%. Even Hong Kong and mainland China were not immune to the selling pressure, though their declines were less severe.
India view:
Despite the global market volatility, the Indian markets have remained resilient as the Sensex closed 2.74% down, while the Nifty 50 crashed 2.68% on Monday. The Indian Markets are now more balanced than before as the markets have also gone through recent major events such as Elections and Union Budget 2024.
“We are booking profits from the Cyclical sectors and the defensive sectors are making a comeback. We expect that IT sector may be the much more affected given the global market uncertainty and specially the sell off on the US tech stocks,” said Tata MF in a note.
What should investors do?
Nirav R Karkera, Head Research at Fisdom Research advises investors to shift to high-quality stocks
Shift to High-Quality Stocks
The market is expected to rotate away from low-growth, low-quality segments toward companies with strong fundamentals and sustainable growth prospects. Suggest investors should prioritize high-quality stocks with a proven track record of delivering consistent returns.
Orientation Towards Large Caps:
Maintain a strong focus on large-cap stocks, as they tend to offer more stability and resilience, especially during periods of market volatility.
Selective Exposure to Midcaps and Small Caps: While large caps should be the core of your portfolio, don’t completely overlook quality opportunities within midcaps and small caps. Look for companies with solid fundamentals, strong growth prospects, and good management in these segments.
Monitor Global Events
The global market correction triggered by the unwinding of the Yen Carry Trade and other factors like US recession fears and Middle East conflicts could continue to create volatility.
Rebalancing Portfolios
Given the potential underperformance of certain sectors and the ongoing global market volatility, it’s a good time for investors to reassess and rebalance their portfolios, emphasizing quality and growth-oriented investments.
Adopt a Long-Term Perspective: Despite short-term volatility, a long-term investment approach focusing on quality and growth will likely yield better results. Stay invested in fundamentally strong companies that are well-positioned to weather market uncertainties and deliver sustainable growth. Keep a close watch on global developments and adjust portfolios accordingly to safeguard against further downside.
Jay Shah, Founder & CEO, Finwisor has the following advice for investors:
1. Long term investors following their asset allocation should relax and do nothing.
2. Those who have invested heavily in small and midcaps, can look at shifting their allocation more towards largecaps
3. Those who have been sitting of cash, can start deploying money.
“With the current risk-off environment, the Indian market may also remain under pressure for some time. Hence, it would be prudent for the investor to have a defensive strategy for the short term with low beta portfolio, allocation to strong businesses available at attractive valuations etc. In these times, investors should avoid SME, Microcap cap, and hope stories based stocks. Further, it would be wise to keep some cash level at the portfolio in order to utilise sharp dip for the buying for long term. Over a medium to long term, the Indian economy is in a sweet spot and markets would also see sharp recovery post-sell-off,” said Ravi Jain, Co-founder & MD, Blostem.
