The Unwinding of the Yen "Carry" Trade

9/9/2024 - By Mark Hemby, CFA®, CFP®

At the start of August, the U.S. stock market experienced an unexpectedly sharp decline, losing over 7% in just the first three trading days. While those losses were eventually recovered, many investors were left wondering what caused such a dramatic sell-off. The answer lies in something known as the "carry trade," specifically, the Yen carry trade. But what exactly is the Yen carry trade, and why did it have such a significant impact on equity markets?

Understanding the Basics

When you purchase an asset, there’s often a cost associated with maintaining that position—this is known in finance as the “cost of carry.” For example, if you’re a wheat supplier, there are costs to store and transport the wheat to your buyers. In financial markets, the cost of carry refers to the interest rate you pay to finance the asset you purchase.

In banking, a bank can borrow and use cash from the market to buy a financial asset like a Treasury bond. If you can borrow at a 4% interest rate and purchase a bond that pays 4.5%, you’ve got a positive carry of 0.50%. Banks can profit from such transactions where the cost of carry is positive. Most often, banks and financial institutions borrow money in the overnight lending market. If you borrow overnight, you must refinance the loan daily. As long as the borrowing rate is lower than the yield on the purchased asset, you have a positive carry.

The Current Market Scenario

Recently, U.S. overnight borrowing rates have been higher than the yields on many assets available for purchase. As of this writing, the overnight rate banks are charged is 5.35%, while a 10-year Treasury bond yields only 4.20%. This creates an unprofitable situation for many financial institutions, pushing them to seek cheaper borrowing rates. And where are the lowest overnight rates? Japan.

Until recently, financial institutions could borrow overnight in Japan at just 0.10%. US fund managers involved in the Yen carry trade deployed the following strategy:

Borrow Yen at a low interest rate.
Convert Yen to another currency, such as the U.S. dollar.
Buy an asset in the other currency that yields more than the original loan.

But this strategy isn’t without risks. There are three primary risks associated with the Yen carry trade:

Borrowing rates in Yen might increase.
Foreign exchange rates could make converting back to Yen more expensive.
The value of the purchased assets might decline.

In this case, all three risks materialized simultaneously. The Bank of Japan recently raised its overnight borrowing rate from 0.10% to 0.25%. While this may not seem significant, for those using leverage to amplify returns, this increase can render the trade unprofitable. When this happens, investors in the carry trade must sell assets (causing prices to drop) and buy Yen (driving up the Yen’s value) to repay their loans. If many market participants are doing the same, the market can experience significant movements.

Indeed, the value of the Yen compared to the U.S. dollar dropped 11%, and the Japanese stock market fell by 18%. These are historically large moves. If the carry trade investors are holding U.S. dollar-denominated assets, the value of those assets may also fall, which explains why many tech stocks recently saw a sharp decline.

The Importance of Diversification

This situation underscores why Saltmarsh Financial Advisors employs a widely diversified strategy. Rather than engage in speculative trades, we focus on a well-diversified asset allocation that aligns with our clients' time horizons, risk tolerance, and long-term goals. Please reach out to us to learn more about how we can assist you with even more strategies for managing your overall wealth.

About the Author | Mark Hemby CFA®, CFP®

Mark is a senior financial advisor for Saltmarsh Financial Advisors, LLC, an affiliate of Saltmarsh, Cleaveland & Gund. He holds both a Chartered Financial Analyst (CFA®) designation and a Certified Financial Planner (CFP®) designation. As part of our investment advisory group, he works with clients to develop and implement investment strategies to achieve financial freedom while also ensuring their goals and objectives are aligned. Mark has over 15 years of experience in investment banking working with individuals and organizations to manage their portfolios and coordinate investment activities. In addition to his experience with fixed income trading and sales, Mark owned and operated his own business in Alabama.