Monday brought gloomy news for investors as the Australasian markets – the first to open, plunged hard, with the latest trigger being the unwinding of yen carry trades. What is this phenomenon? Does it possess the potential to scar the market for a longer term?

The Trade That Thrived: The yen carry trade, a popular strategy, results when investors take advantage of the ultra-loose monetary policy of the Bank of Japan, which maintained a negative interest rate for about eight years until March and at a very nominal 0-0.1% until late-July.  This marked the first hike in 17 years.  

Global investors capitalized on this and borrowed yen at very low interest rates and used the capital to purchase investments denominated in another currency in a country that has a higher rate of return. This carry trade worked fine until Japan's interest rates remained at extremely depressed levels.

The Chinese yuan is also one of the favored currencies for carry trade.

Subsequently,  the BOJ announced an increment to its key interest in late July to around 0.25%,

What Went Wrong? After BOJ decided to do away with its ultra-loose policy, the yen began to appreciate against most major currency pairs. Since March 19, when Japan's central bank announced its first rate increase since 2007, the yen has appreciated 5.4% against the U.S. dollar.

The yen currently traded at JPY 143.05 versus the greenback, up 2.39%. Traders who resorted to this strategy are now staring at losses. The U.S. dollar assets they now hold, bought with borrowed yen loans, may be inadequate to make repayment, forcing them to unwind their bets.

Weakening U.S. economic fundamentals are not helping the dollar's cause either. Recent data points from the world's largest economy have been sore. Manufacturing activity is contracting and job market strength is fading even as inflation, despite its cooling, weighs down on consumer spending.

Ben Emons, Managing Director of Global Macro Strategy at Medley, sounded out the possibility of more pain. "The Yen carry trade unwind is far from over, with total net shorts being barely covered," he said on X.

The Yen Carry trade unwind is far from over, with total net Yen shorts being barely covered pic.twitter.com/qNhVBwFhLp

— Global_Macro (@Marcomadness2) August 3, 2024

Japan's Nikkei 225 average plunged 12.40% amid the mayhem on Monday before settling at 31,458.42. This came on top of the 5.8% plunge on Friday. Intraday, the index slumped 13.4%, marking the biggest single-day drop since a nearly 15% plunge in Oct. 1987 on the day dubbed "Black Monday."

South Korea's Kospi had to be halted amid a plunge and ended Monday's session down 8.77% at 2,441.55.

iShares MSCI World ETF (NYSE:URTH)ended Friday's session down 1.83% at $144.62, according to Benzinga Pro data.

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