SINGAPORE, Aug 7 (Reuters) - Global stock and bond
markets, in particular Japan's, are being rocked by an unwinding
of the hugely popular yen carry trade.
That trade, which involves borrowing yen at a low cost to
invest in other currencies and assets offering higher yields, is
being wrecked by Japan's rate increases, a volatile yen and
imminent rate cuts in the United States and other economies.
Here is a deeper look at the yen carry trade.
HOW DOES THE CARRY TRADE WORK?
It involves borrowing the yen, or any other currency
with similar super-low interest rates, then using it to buy
currencies with better yields.
The yen has been the funding currency of choice for carry
trades in U.S. dollars, Mexican pesos, New Zealand
dollars and some others.
The trade involves buying the higher-yielding currency with
the borrowed yen to invest in bonds or other money market
instruments in that currency.
At the end of a usually short-term trade, the investor
converts the dollars or pesos back into yen, and repays the
loan.
Annualised returns typically can be around 5% to 6% on
dollar-yen carry trades, which is the difference between U.S.
and Japanese rates, with a scope for more gains were the yen to
depreciate during that term.
WHAT IS THE GENESIS OF THE YEN CARRY TRADE?
If defined broadly as using a low-yielding yen to buy
higher-yielding foreign assets, then its origins can be traced
back to 1999 when Japan struck policy rates down to zero after
its asset price bubble burst.
The Japanese turned to international markets to get anything
better than the zero yields at home, ploughing trillions of
dollars into foreign markets and thus turning Japan into the
world's biggest creditor nation.
The carry trade as we know today, which involves yen
borrowing by largely international investors, kicked off in 2013
under Prime Minister Shinzo Abe's quantitative and qualitative
easing that coincided with rising rates in the United States and
a depreciating yen.
Those trades reached new, gargantuan proportions over the
course of 2022 and 2023 as the Federal Reserve raised rates
rapidly to rein in inflation even as the Bank of Japan (BOJ)
kept its short term rates negative, and as the yen swooned.
HOW LARGE IS THE YEN CARRY TRADE?
No one is quite sure. Using the narrowest definition of a
pure currency carry trade, analysts point to the $350 billion of
short-term external loans by Japanese banks as one estimate of
yen-funded trades in the world.
That number could be an exaggeration if some of those loans
are commercial transactions between banks or loans to foreign
businesses needing yen.
But it could be also understating the actual size of yen
carry trades because there could be billions of yen the Japanese
themselves have borrowed to invest in markets at home.
Actual positions could be amplified because of how hedge
funds and computer-driven funds use leverage.
Add to that the massive investments Japanese pension funds,
insurers and other investors have made abroad. Japan's foreign
portfolio investments were 666.86 trillion yen ($4.54 trillion)
at the end of March, Ministry of Finance data shows - more than
half in interest rate-sensitive debt assets, albeit most of it
long term.
WHY IS THE YEN CARRY TRADE UNRAVELLING?
To be sure, the BOJ has only started raising rates and its
overnight rate is just at 0.25% while dollar rates are roughly
5.5%.
But carry trades are more sensitive to currency moves and
rate expectations than the actual level of rates, analysts say.
The mere talk of further rate rises in Japan and Fed rate
cuts by September has driven the yen up 13% in a month and
narrowed the yield gap, completely wiping out the slim gains in
pure yen-dollar carry trades.
And as the big leveraged investors cut their billions of
loss-making yen carry positions, they are being forced to
de-leverage and shed other stock and bond holdings.
($1 = 146.8600 yen)