The yen carry trade, a longstanding financial strategy of borrowing cheaply in Japan to invest in higher-yield assets abroad, is undergoing a rapid and disruptive unwinding. The surprise rate hike by the Bank of Japan (BoJ) and a widely perceived need for swift rate cuts in the US have triggered significant market retractions, highlighting the fragile balance underpinning global financial markets.
Notable periods of yen carry trade unwinding include the 1998 Asian Financial Crisis and the 2008 Global Financial Crisis. During both crises, investors repatriated funds to Japan, leading to a sharp rise in the yen’s value. This repatriation triggered a credit crunch, as financial institutions faced liquidity shortages, resulting in widespread market volatility. The volatility quickly spread globally, prompting international organisations and central banks to coordinate responses to stabilise financial markets.
“It’s hard to say whether we are heading towards the same scenarios, however risks are high, and remaining cautious in highly cash instruments might be key at this stage,” Althea Spinozzi, head of fixed income strategy at Saxo told Investment Officer.
‘Double shock’
Vincent Juvyns, global market strategist at JP Morgan Asset Management, describes the situation as a “double shock” stemming from the unexpected Japanese rate hike and rising expectations of rate cuts in the US, spurred by Friday’s disappointing unemployment figures. “This is clearly an exaggerated move, but not a reason to panic, nor a time to buy. The volatility may well continue for a few more days.”
Estimating the exact impact of yen carry trades is challenging. Mostly hedge funds engage in these trades. The investments of Japan’s government may be even more important. Deutsche Bank chief FX strategist George Saravelos last November published a widely discussed note arguing that the government of Japan is effectively engaged in one massive 20 trillion dollar carry trade. With a debt-to-GDP ratio well above 200 percent, the BOJ, he said, can only hike rates. It did not do that until last week.
Toxic dilemma
The BOJ faces a toxic dilemma: tighten policy, and the carry trade unwinds, risking financial stability; or delay, and increasing financial repression could collapse the yen. It’s a choice also between generations. “If the carry trade unwinds, older and wealthier households face higher inflation; if delayed, younger and poorer households face declining real incomes,” Saravelos wrote
According to the OECD, Japanese pension funds, which hold about 1,300 billion dollars in assets—comparable to Switzerland’s pension funds and slightly less than those of the Netherlands—some 56 percent, according to the Federal Reserve, in investments abroad, mainly in the US and big tech stocks. These foreign investments function similarly to carry trades. Should these funds decide to repatriate their investments amid shifting interest rate expectations and a strengthening yen, it could further bolster the yen’s value, complicating the financial landscape.
The impact on Japanese companies, known for their conservative treasury management, and retail investors such as ‘Mrs. Watanabe’, is seen as limited, analysts said. Despite recent corporate governance reforms encouraging Japanese companies to hold less cash, they remain risk-averse. Private investors still hold 54 percent of their assets in cash and deposits, according to OECD data.
‘Reduced liquidity globally’
If the yen appreciates significantly and remains strong over the long term, it could have lasting effects on Japan’s economy. A stronger yen can make Japanese exports less competitive, potentially leading to a trade imbalance and slower economic growth for Japan.
Saxo’s Spinozzi said the deterioration in the Japanese stock market might initially be offset by the repatriation of yen based investors, as they will be less inclined to buy foreign financial instruments at the risk of the foreign currency depreciating. But ultimately, it’s bad news for global markets.
“The unwinding of the carry trade ultimately means reduced liquidity globally as investors withdraw investments from various markets. Sustained reduced market liquidity translates in periods of sustained volatility, reducing investors’ risk appetite,” Spinzzo said.
‘Gradual normalisation’ seen in Japan
Juvyns believes that Japan will continue to have the lowest interest rates among central banks globally due to its high national debt. “Even with some interest rate hikes, Japan will remain the world’s central bank with the lowest rate. The BoJ cannot do otherwise because of the high national debt. Their interest rates will remain relatively low and it will certainly not be the end of carry trades either. The gap will remain.”
Juvyns said he anticipates a “gradual normalisation” of the BoJ’s interest rate policy that could extend until the middle of 2026. He cautions though that unforeseeable events could occur between now and then, but the BoJ must remain financially restrictive due to Japan’s debt obligations. Unless inflation returns, which is doubtful given the cooling Japanese economy, the low-rate environment is likely to persist.
From a global perspective, expectations regarding US interest rates might eventually be more important than the higher rates in Japan. “It seems to me that the unwinding of the carry trade has more to do with the repricing of the US interest rate outlook following the jobs data rather than the relatively small rise in Japanese policy rates,” said Martin Mulligan, managing director at Vuca Treasury in London, responding to Investment Officer.
As of March 2023, Japan’s public debt is estimated to be around 9.2 trillion dollars in yen, equating to 263 percent of its GDP. This is one of the highest debt ratios among developed nations, with 43.3 percent of this debt held by the BoJ.