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This year on March 26th Japan’s central bank, the Bank of Japan (BOJ) decided to end its negative interest rates policy. BOJ for the first time raised the interest rate by 10 basis points to fight rising inflation. As a result of this the Yen (¥) started depreciating against the US Dollar ($).
This interest rate parity and the increase in Dollar/Yen difference, lead to an increase in “Yen Carry Trade”
What is a Carry Trade?
A carry trade in simple terms is a trading strategy where an investor borrows currency from a country with lower interest rates (called the funding currency) and invests in another country with higher interest rates (called the target currency).
Here the aim is to make a profit from the interest rate difference of the two countries.
Let's take a look at two scenarios:
Scenario 1:
While Borrowing:
Interest rate in Japan: 0.10%
Interest rate in the US: 5.5%
1 USD = 155 JYP
While Repaying:
Interest rate in Japan: 0.10%
Interest rate in the US: 5.5%
1 USD = 160 JYP
Here the trader makes a profit due to the interest rate difference and because during the time he was invested, the borrowing currency depreciated more, strengthening the dollar. So while converting back he received more Yen plus the higher interest rate leading to profit.
On August 5th, BOJ decided to raise interest rates for the second time this year because it wasn’t in favour of the weak yen, which led to increased import costs, thus leading to inflation. Also, this was seen in line with what major global central banks have been doing with their domestic interest rate. The US Fed has been increasing rates, hence the other central banks followed this trend as well.
This leads us to scenario 2.
Scenario 2:
While Borrowing:
Interest rate in Japan: 0.10%
Interest rate in the US: 5.5%
1 USD = 155 JYP
While Repaying:
Interest rate in Japan: 0.25%
Interest rate in the US: 5.5%
1 USD = 145 JYP
Here the trader ends up making a loss as his investment when converted back is less than the borrowed amount due to Yen appreciation.
Hence a carry trade is only favourable when the exchange rate moves in favour of the target currency, which in this case is USD. But since the USD weakened against JYP this went against the carry traders.
Impact on global markets:
As the traders brought back the Yen to repay the loans the currency appreciated leaving them USD buying lesser Yen in amount.
To close the loans the traders had to sell their foreign assets across various countries.
The US markets saw a sharp decline, due to various factors such as high inflation and interest rates, lower growth projections and the recent release of unemployment data showing a decline in hiring rates. The yen carry trade was one of the contributing factors.
This sharper decline in US markets and low economic prospects lead to border fear of a global economic downturn. As a result, Japan’s Nikkei index saw a 7% drop, and India’s Sensex saw an approx. 2000 points drop in a single day.
As investors adjusted their portfolios, the bond market saw increased volatility, with yields rising sharply. This was particularly concerning for U.S. Treasuries, where yields jumped, putting additional pressure on borrowing costs.
Countries with significant foreign investments saw their currencies weaken and asset prices tumble as the flight of capital took place back to Japan.
These conditions of fear triggered investors who had borrowed Yen and invested in countries like the US, the UK, and even emerging countries like Brazil and India, to start selling their assets due to increasing volatility and a possibility of further increase in interest rates by BOJ.
The recent events surrounding the BOJ’s decision to raise interest rates serve as a stark reminder of how interconnected the global financial system is. A policy shift in one of the world’s largest economies can have far-reaching consequences, triggering market sell-offs, currency fluctuations, and increased economic uncertainty. As the world adjusts to this we now wait and see how the Federal Open Market Committee (FOMC) reacts to this turmoil situation.
Thank you.
Regards,
Kautilya, IBS Mumbai.
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