On Monday, August 5, major stock markets worldwide experienced their steepest decline in decades. This drop was fueled by various factors, including the increasing likelihood of an economic recession in the US and rising geopolitical tensions in West Asia. However, a significant new trigger was the unwinding of the yen carry trade.
Understanding Yen Carry Trade
The yen carry trade involves global investors borrowing money in Japan, where interest rates are low, and investing it in countries with higher interest rates. This strategy takes advantage of the differing interest rate environments maintained by central banks in various countries to suit their economic conditions.
For instance, Japan's central bank, the Bank of Japan (BoJ), kept interest rates at zero percent from 2011 to 2016 and even pushed them below zero (-0.10%) since 2016. Such low interest rates are intended to stimulate economic activity by making borrowing cheaper.
Global Ramifications of Yen Carry Trade
Japan, being the world's third-largest economy, has a significant impact on global financial markets. The yen is a trusted currency, and low interest rates incentivize investors to borrow cheaply in yen and invest in higher-yielding assets in other countries like Brazil, Mexico, India, and the US. These investments, known as yen carry trades, involve billions of dollars and have fueled growth in multiple economies.
What Changed?
Between mid-March and the end of July, the BoJ raised interest rates by 35 basis points, changing the rate from -0.1% to 0.25%. While this increase might seem small compared to countries where lending rates are much higher, in Japan's context, it was a significant shift. This change was perceived as a monetary earthquake, and further rate hikes are anticipated.
The Unwinding of Yen Carry Trade
The 25 basis point increase announced on July 31st led to the unwinding of the yen carry trade. Investors who had borrowed in yen and invested in other currencies like the Brazilian real, Mexican peso, or Indian rupee started selling their international assets.
Why the Unwinding Happened
Higher interest rates in Japan made the yen stronger against the dollar and other emerging market currencies. The yen's exchange rate improved against the dollar, real, rupee, peso, and more. Consequently, assets held in these currencies were worth less when converted back to yen. Additionally, the higher opportunity cost of the yen carry trade, given the increased returns on yen investments, made such trades less attractive.
This narrowing of returns differential triggered a market slide as investors sold off assets bought with cheap yen. The expectation of further rate increases by the BoJ exacerbated this sell-off, leading to significant declines in stock markets globally.