The so-called “yen carry trade” has been making headlines recently, with many pointing fingers at this investment strategy as the cause of recent turmoil in global markets.
Yen trading involves borrowing at near-zero interest rates in Japan and investing the proceeds in higher-yielding markets such as the US dollar, emerging markets or global technology stocks.
When investors quickly unwind these trades, they can spread across global markets. In fact, this was one of the main factors that led to the recent global stock market rout.
According to UBS strategists, a series of developments have made the yen trade look riskier.
An unexpected interest rate hike by the Bank of Japan on July 31 raised concerns about further increases. At the same time, fears of a U.S. recession and expectations of a rate cut by the Federal Reserve have narrowed the interest rate advantage that the carry trade relies on. Those invested in U.S. technology stocks have also faced waning confidence in the prospects for artificial intelligence.
The trade takes advantage of a country’s low interest rate to invest in higher-yielding assets abroad. This strategy relies on the spread, or “interest,” between the low-cost borrowing rate and the higher-yielding investments.
However, UBS points out that this approach could backfire if the value of the funding currency rises sharply, if the interest rate gap narrows, or if returns on the invested assets falter.
The strategy gained wide popularity in 1999, when the Bank of Japan cut interest rates to zero in response to persistent deflation, strategists noted.
The yen is a favorite for carry trades because of Japan’s long-standing low interest rates, even experimenting with negative interest rates until March 2024. In contrast, the Swiss franc, another potential funding currency, has seen more rate hikes, reducing its appeal. Japan’s tolerance for a weaker yen also boosts the yen’s appeal for carry trades.
Assessing the size of the yen trade is crucial to understanding the potential risks in the market. Contrary to some media claims of trillions of dollars at risk, UBS strategists argue that such figures are exaggerated.
“We believe that the trades at risk of rapid liquidation are much smaller,” the strategists said.
They classify yen trading into three types:
1) ‘Fast money“These positions are often leveraged and based on futures contracts, and most of them have been liquidated as the yen has appreciated. Data from the Commodity Futures Trading Commission (CFTC) supports this.
“A series of CFTC reports indicate that most of these trades have already been liquidated as the yen has appreciated against the dollar since its lows in early July. The Japanese currency’s rapid rise since late July appears to have halted this process.”
2) ‘semi fast moneyAccording to UBS, this involves borrowing yen to invest in higher-yielding currencies or stocks. Data from the Bank for International Settlements shows an increase of about $94 billion in yen borrowing since mid-2022, roughly the same period as the interest rate gap between the Fed and the Bank of Japan widened.
3) ‘sticky moneyLong-term investments by Japanese pension funds and insurance companies, such as the Government Pension Investment Fund. Strategists believe these investments are “not at high risk of being sold and repatriated.”
Most of the “fast money” trades have already been liquidated, and “hard money” investments have stabilized. UBS notes that the main risk lies in “near-fast money” trades, which amounted to $94 billion.
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