Carry Trade Explained

Answer: In its simplest form the “carry trade” is borrowing funds from a source with low interest rates and investing those funds with the intention of obtaining   higher rates of return. Today’s financial markets are global in nature, allowing investors to look for the best opportunities around the world. Recently, the Japanese yen provided a low-cost source of funds. Investors “borrowed” funds and invested them at the same time. Here’s how the popular Japanese yen carry trade worked, until it didn’t.

Step 1: Borrow at near zero interest rates. The average Fed Funds rate has been 5.3% since the end of 2022 while the Bank of Japan's average interest rate was 0.05%. Borrowers went to Japan and borrowed yen. Currency investing is generally considered speculative because of the significant potential for investment loss. These markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. This is not a recommendation to employ a yen carry trade strategy. At some point, the borrowed yen must be returned, with intentions of making a profit on the investment side of the equation. 

Step 2: Invest in potentially higher-yielding assets. This makes the trade risky beyond just the cost of borrowing funds. If these investments go down, the trade is ineffective resulting in negative performance. On the global stage, international investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. 

Step 3: Watch for currency swings. If the funding currency (yen) appreciates, it is more expensive to repay the loan, and if it depreciates, it may be less expensive to pay back the loan. Prior to July 10, the yen had depreciated almost 23% since the end of 2022 which was a big advantage to borrowers. 

The carry trade had been a winning trifecta with cheap borrowing costs, appreciation of the assets purchased, and a depreciating yen. And the more the trade has worked, the more money went after the strategy. 

So, what happened? Just like in the game “musical chairs” when the music stops, the carry trade abruptly ended when the Bank of Japan increased interest rates. This made the borrowing component of the trade more expensive. At the moment, The Bank of Japan is the only major central bank raising interest rates while others are either cutting or expected to cut.

The weak US employment report further fueled expectations of aggressive rate cuts by the Federal Reserve. Lower US interest rates, weaker US economic data and a softer economy are headwinds to the yen carry trade strategy. This made investors nervous, leading to the unwinding of the yen carry trade. This led to selling (and as we know, selling begets more selling) assets and converting the dollar back into yen to repay the loan. This creates a feedback loop pushing assets prices down further, and the yen up. And on and on it goes. 

Although the unwinding of the carry trade increased volatility and was the catalyst for a market downturn, it’s important to remember that especially in the US, the fundamental evaluation of companies remains the long-term driver of markets. The direction of the US economy, how the Fed will manage rates, and earnings outlooks influence market behavior. Volatility will remain as we digest political and economic uncertainty. All of this makes the importance of having a personalized financial plan to assist you in weathering market ups and downs even more significant and meaningful. Stay focused and plan accordingly. 

Data sources: Bloomberg, FactSet, both as of 8/8/2024                   

CURRENCIES | The foregoing is not a recommendation to employ a yen carry trade strategy.