There has been a lot of financial news recently around something called the "carry trade". Last week, Japan’s central bank raised its benchmark interest rate to “around 0.25%” from it previous range of 0% to 0.1%. This would mark the highest interest rates since October 2008, when it was set at 0.3%, and catalyzed a deep sell-off of the Japanese equity markets that carried forward to the US markets the following morning. Net selling continued over the next few trading days around the world and global markets retreated near correction territory. What drove all of that selling? Investors began to unwind massive carry trades.
When it comes to financial markets, few strategies have as much allure—or risk—as the carry trade. This investment strategy, while popular among seasoned traders, can seem complex to the average investor. In this post, we’ll break down what the carry trade is, how it works, and why recent moves in Japan’s interest rates have led investors to unwind their carry trades. We'll also explore the math behind why borrowing in Japan has been so attractive until recently.
What is the Carry Trade?
At its core, the carry trade is a strategy where investors borrow money in a currency with a low interest rate and invest it in a currency with a higher interest rate. The goal is to profit from the difference between the borrowing cost and the return on the investment.
For example, imagine you can borrow Japanese yen at an interest rate of 0.1% and invest the proceeds in U.S. dollars, which offer a 5% return. The difference, known as the "carry," would theoretically yield a profit.
How Do People Execute a Carry Trade?
Executing a carry trade involves a few key steps:
Borrow in a Low-Interest-Rate Currency: Investors start by borrowing in a currency that has a low-interest rate, such as the Japanese yen (JPY) or the Swiss franc (CHF).
Convert the Borrowed Funds: The borrowed funds are then converted into a currency with a higher interest rate, such as the U.S. dollar (USD) or the Australian dollar (AUD).
Invest in Higher-Yielding Assets: The converted funds are invested in higher-yielding assets, like government bonds, stocks, or real estate.
Earn the Difference: The investor earns the difference between the cost of borrowing and the return on the investment. If the exchange rate between the two currencies remains stable or moves in favor of the investor, the profit can be significant.
The Appeal of the Carry Trade: Why Borrowing in Japan?
For years, Japan has maintained one of the lowest interest rates in the world, even implementing negative interest rates at times to stimulate its economy. This made the Japanese yen (JPY) an ideal currency for the carry trade. Here’s the basic math:
Borrowing Rate in Japan: 0.1%
Investment Return in the U.S.: 5%
In this scenario, the investor would earn a 4.9% return, assuming no changes in the exchange rate. This difference might seem small, but when leveraged—meaning the investor borrows a large amount—the profits can be substantial.
Unwinding the Carry Trade: The Impact of Japan’s Interest Rate Moves
Recently, however, Japan has signaled a shift in its monetary policy, moving away from ultra-low interest rates. As the Bank of Japan (BoJ) considers raising rates, the dynamics of the carry trade begin to change.
When Japan increases its interest rates, two things happen:
Higher Borrowing Costs: The cost of borrowing in yen rises, making the carry trade less profitable or even unprofitable. For instance, if Japan’s interest rates were to increase to 2%, the return on the carry trade would drop to 3% (5% - 2%).
Currency Appreciation: Higher interest rates can lead to a stronger yen, which poses a risk for those who have borrowed yen. If the yen appreciates against the dollar, investors will need to pay back more in dollar terms when converting their profits back into yen, further eroding potential gains.
The Unwind: What Does It Mean?
"Unwinding the carry trade" refers to the process where investors close out their positions in response to changing economic conditions, such as rising interest rates. In practice, this means selling the assets they invested in (e.g., U.S. bonds or stocks) and buying back the yen they originally borrowed.
This can create significant market movements:
Asset Price Declines: As investors sell off their holdings, the prices of those assets (such as bonds or stocks) may fall.
Currency Volatility: Large-scale buying of yen can lead to a rapid appreciation of the currency, causing volatility in the forex markets.
The Math: Why Borrowing in Japan Was Preferable
Let’s break down the numbers with a hypothetical example:
Initial Scenario:
Borrow 1 million yen at 0.1% interest.
Convert to USD at an exchange rate of 1 USD = 100 JPY.
Invest $10,000 USD (the converted amount) in a U.S. bond yielding 5%.
Profit Calculation:
Interest on U.S. bond: $10,000 * 5% = $500
Interest on borrowed yen: 1,000,000 JPY * 0.1% = 1,000 JPY (or $10)
Net profit: $500 - $10 = $490 (ignoring currency fluctuations).
Now, let’s assume Japan raises its interest rates to 2% and the yen appreciates:
New Scenario:
Interest on borrowed yen: 1,000,000 JPY * 2% = 20,000 JPY (or $200).
Yen appreciates to 1 USD = 95 JPY, so your $10,490 (initial principal + profit) now converts back to 996,550 JPY.
After repaying the loan (1 million JPY), the investor is left with a loss of 3,450 JPY.
This simplified example illustrates how rising interest rates and currency appreciation can turn a profitable carry trade into a losing proposition, prompting investors to unwind their positions.
Conclusion
The carry trade has long been a favored strategy for investors seeking to capitalize on global interest rate differentials. However, as Japan signals a shift in its monetary policy, the profitability of borrowing in yen to invest elsewhere is waning. Understanding the mechanics of the carry trade and the risks involved is crucial for any investor considering this strategy, especially in a changing economic landscape.
The information presented in this blog post is intended for informational purposes only and should not be construed as financial advice or an offer to buy or sell any securities. The analysis and opinions expressed are based on publicly available data and the author's interpretation of current economic trends. However, they do not take into account your individual financial circumstances, risk tolerance, or investment objectives.
Investing involves inherent risks, and past performance is not necessarily indicative of future results. The value of your investments can go down as well as up, and you could lose some or all of your principal. Before making any investment decisions, it is crucial to consult with a qualified financial advisor who can assess your specific situation and recommend suitable investment strategies based on your risk tolerance and investment goals. Always conduct your own thorough research and due diligence before making any investment decisions.
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