The Impact of Carry Trades on Global Markets

On a tumultuous Monday, Japan’s benchmark Nikkei 225 index experienced a staggering decline of 12.4%, while markets across Europe and North America faced significant downturns. This widespread sell-off was largely driven by traders scrambling to cover mounting risks associated with investments financed through low-cost loans, primarily borrowed in Japanese yen. The aftermath of this market upheaval continued to be felt as fears of an impending recession in the United States, the world’s largest economy, combined with anxiety over inflated technology stock valuations, loomed large.

However, on Tuesday, the markets managed to recover a substantial portion of their losses. Despite this rebound, the lingering effects of the previous day’s turbulence were palpable. The sharp declines were exacerbated by a wave of selling, particularly in US dollars, linked to carry trade strategies that had previously propelled markets to unprecedented heights.

What are Carry Trades?

Carry trades are a financial strategy that involves borrowing in a currency with low interest rates to invest in assets or currencies that offer higher returns. A recent example of this phenomenon is the practice of borrowing Japanese yen, with the expectation that the currency will remain undervalued against the US dollar and that Japanese interest rates will stay low. Traders would then allocate these borrowed funds to purchase US stocks and Treasury bonds, anticipating greater returns.

Why Are Traders Unwinding Their Carry Trades?

The primary driver behind carry trades is the disparity in interest rates between different countries. For years, the Bank of Japan has maintained interest rates at or near zero in a bid to stimulate economic growth and consumer spending. However, last week marked a pivotal moment as the central bank raised its key interest rate from nearly zero. This shift in policy typically leads to an appreciation in the value of a nation’s currency, resulting in a significant surge in the value of the Japanese yen against the US dollar.

In response to the increased borrowing costs, traders were compelled to divest from high-risk, dollar-denominated assets to cover their positions. This included not only absorbing losses from fluctuations in foreign exchange rates but also navigating the fallout from declining share prices. Additionally, hedge funds engaged in carry trades often rely on sophisticated computer models to optimize their risk-reward profiles, necessitating the sale of shares to maintain acceptable risk levels.

Why Do Carry Trades Affect Markets So Drastically?

Carry trades are most effective when foreign exchange rates demonstrate relative stability, allowing investors to capitalize on higher-yielding opportunities, such as the recent surge in stock prices in the United States. However, the recent market volatility forced traders to liquidate their positions by purchasing yen and other currencies associated with carry trades, while simultaneously offloading higher-risk assets acquired under more favorable circumstances.

While carry trades can be highly profitable during periods of rising asset values, they pose significant risks when numerous traders are pressured to sell simultaneously. As Stephen Innes of SPI Asset Management aptly noted, “A massive global carry trade unwind was the spark that lit the fuse for this market Armageddon.” He also emphasized that such sell-offs can create a vicious cycle, amplifying market volatility.

What Are the Future Risks Associated with Carry Trades?

The gap between Japan’s main interest rate, now at 0.25%, and the Federal Reserve’s benchmark rate of 5% to 5.25% remains substantial. However, as the Fed is anticipated to lower rates and Japan is poised to increase its rates, this disparity is likely to diminish. On Tuesday, financial markets showed signs of stabilization, with Japan’s Nikkei 225 index rebounding by 10.2% and many other markets trending upward. Analysts remain divided on whether this wave of volatility has passed or if further turbulence lies ahead.

Regardless, carry trades have been a fixture in financial markets for decades, previously contributing to the financial crisis in Iceland’s sector during 2007-2008, where investors borrowed in yen or Swiss francs to exploit higher Icelandic interest rates. During the recent upheaval, Mexico, another focal point for the yen carry trade, saw its peso depreciate by over 6%. The popularity of this complex trading strategy underscores its potential as a wildcard for investors, particularly in periods marked by heightened market volatility.