Yen Carry Trade Unwinding Is Not Over, Here's What Investors Need to Watch

Over the past several days, financial markets worldwide have experienced dramatic fluctuations, with notable activity ricocheting from the United States to Japan and across emerging markets. The tumble began from Thursday last week. On Monday, August 5, the Japanese stock market index, Topix, again experienced a significant downturn, closing 12% lower, marking its worst performance since 1987. Meanwhile, the S&P 500 index also saw a substantial pullback, retreating as much as 9% from its peak.The volatility index in the US surged to 65.73 on Monday, a level only previously seen during the 2020 COVID shock and in 2008.

The reason for the market plunge is due to recession concerns sparked by nonfarm employment falling short of expectations, technology stock earnings not significantly exceeding expectations, and the unwinding of yen carry trades caused by Japan's interest rate hike.

The yen carry trade, characterized by taking advantage of low borrowing costs in yen to invest in higher-yielding currencies and assets, is being disrupted by Japan's interest rate hikes, a fluctuating yen, and the prospect of imminent rate reductions in the United States and other economies.

The yen has traditionally been the preferred funding currency for carry trades involving the U.S. dollar, Mexican peso, New Zealand dollar, among others. This strategy entails using the borrowed yen to purchase a higher-yielding currency, which is then invested in stocks or other financial instruments denominated in that currency. These trades, which are typically short-term, end with the investor exchanging the dollars or pesos back to yen to repay the borrowed amount.

Carry trades between the dollar and yen can typically yield annualized returns of about 5% to 6%, reflecting the interest rate differential between the U.S. and Japan, with the potential for additional profits if the yen weakens during the period of the trade.

However, recent speculation about further rate increases in Japan combined with anticipated Federal Reserve rate cuts by September has resulted in the yen strengthening by 13% within a month, narrowing the interest rate differential and erasing the marginal profits from straightforward yen-dollar carry trades.

Furthermore, as significant investors with leveraged positions in yen carry trades face losses, they are compelled to reduce leverage and liquidate their positions in other stocks and bonds.

The correlation between the rise of the yen exchange rate and the decline of the Nasdaq 100 index futures reached 0.55, especially during the Asian trading hours, when the pre-market decline of the US stock index was particularly evident.

The unwinding of the carry trade has happened more than once in history. On the Black Monday crash of October 1987, the index lost 3,836.48 points (14.9%), the worst previous decline.

Ed Yardeni, president of Yardeni Research, said, "This easily reminds people of 1987. We had a stock market crash—basically all within one day—and people thought we were already or about to enter a recession. But that didn't happen at all. It actually had to do with the internal structure of the market."

In the past scenario, former Fed Chairman Alan Greenspan cut interest rates and injected liquidity into the financial system. Yardeni expressed his expectation that monetary authorities would react to the present circumstances, though he did not foresee an immediate rate change.

During the mid-2000s, a significant part of the Japanese yen carry trade involved foreign banks' Japanese branches acquiring yen and then transferring it back to their headquarters. This time, however, the situation seems different. Data indicates that the scale of short-selling by foreign banks is only about half of what it was in 2007. Other types of traders, such as macro hedge funds and CTAs (Commodity Trading Advisors) tracked by Hedge Fund Research (HFR), are playing a more significant role.

According to Japan's balance of payments statistics, Japanese investors' investment in U.S. asset portfolios has increased much more than investments in other countries. In the meanwhile, the unwinding of the carry trade is largely only affecting the stock market, while the investment-grade corporate bond market is still seen by investors as a haven. Historically, the VIX index, which reflects volatility, has a high positive correlation with the CDX index of investment-grade bonds, Bloomberg's analyst Trace Alloway noted. However, recent trends indicate that the risk has not yet spread to the corporate bond sector.

Historical experience suggests that the current unwinding of the carry trade could continue. During the early signs of the 2007 subprime crisis, and when Long-Term Capital Management (LTCM) collapsed in 1998, the yen appreciated by 20% from its trough. As of August 6, the yen has only appreciated about 10% from its recent low against the dollar. Data from the options market indicates that the cost of put options on the dollar is far higher than that of call options.

Arindam Sandilya, the head of global exchange at J.P. Morgan, believes the carry trade unwinding process is only 50%-60% complete. He further stated, "The majority would likely agree that the yen stands as the most undervalued currency among both developed and emerging markets." Sandilya noted that J.P. Morgan's analysis has indicated that once initiated, significant shifts such as the yen's swift recent surge often persist, albeit with reduced momentum. "In a number of these cases, the trend typically carries on, though at a diminished speed compared to the initial phase," he elaborated.

Analysts from Citi also said that the end of yen arbitrage requires "the Federal Reserve to cut interest rates three times, which will take at least six months." The institution pointed out that historically, after an upward trend, the threshold for the U.S. dollar to Japanese yen to turn downward is a U.S.-Japan interest rate differential of about 4.75%. Currently, this differential is around 5.25%.

Ripple effects could also spread to other economies. In terms of emerging market currencies, the Mexican and Colombian pesos, like the Japanese yen, are the main borrowing currencies for carry trade. Exchange rate fluctuations may also be transmitted to peripheral countries in the Eurozone. For example, the withdrawal of large amounts of capital has pushed up the bond yields of Italy and Spain.

There is no concrete data available that pinpoints the exact magnitude of the yen carry trade. Yet, the simplest indicator for monitoring the unwinding trend is to track the net short yen positions, with data sourced from the U.S. CFTC (Commodity Futures Trading Commission). The latest number shows that short positions in the yen are rapidly decreasing but have not yet completely disappeared. The next weekly data, which could further show how quickly yen shorts have been reduced, will be released on August 9.

Source: Bloomberg, Investing.com, Citi, JPMorgan