As global markets witnessed turmoil this past week, a market strategy known as the “carry trade” played a significant role in the chaos. The plunge of Japan’s Nikkei 225 by 12.4% on Monday triggered outsized losses in European and North American markets, fueled by traders selling stocks to offset increasing risks from investments financed with cheaply borrowed funds primarily in Japanese yen. Although markets made a partial recovery on Tuesday, the repercussions of the turmoil linger.
-
What are carry trades?
Carry trades involve borrowing funds at low interest rates in one currency to invest in another currency offering higher returns. For instance, traders borrow Japanese yen, anticipating its value to remain low against the U.S. dollar and expecting Japanese interest rates to stay low. These borrowed funds are then invested in U.S. stocks and Treasury bonds in anticipation of greater returns. -
Why have traders been unwinding their carry trades?
The driving force behind carry trades is usually the difference in interest rates between the two currencies involved. Recently, the Bank of Japan increased its interest rate from almost zero, instantly boosting the yen’s value against the U.S. dollar. Consequently, traders scrambled to sell dollar-denominated assets to cover escalating borrowing costs, foreign exchange losses, and declining asset values as stock prices plummeted. -
Why do carry trades have an outsized impact on markets?
Carry trades are most viable when exchange rates are stable, allowing investors access to high-yield market opportunities, like the recent bullish trend in U.S. stock prices. However, the recent market upheavals compelled traders to settle their debts by purchasing yen and other carry trade currencies while selling off their higher-risk assets acquired under more favorable circumstances. The snowballing effect of losses occurs especially when numerous traders are induced to simultaneously sell their stocks or assets. - What’s the future risk from carry trades?
The significant interest rate disparity between Japan’s rate of 0.25% and the Federal Reserve’s rate range of 5%-5.25% is expected to narrow as Japan hikes its rates and the Fed lowers theirs. Even though markets seemed to stabilize on Tuesday with the Nikkei 225 index soaring by 10.2%, analysts are divided on whether the market volatility has subsided or more turbulence awaits. Carry trades have a storied history, contributing, for example, to Iceland’s financial crisis in 2007-2008. As seen in the recent market unrest, countries like Mexico, also embroiled in the yen carry trade, experienced a significant fall in their currency. Despite its popularity, the complex nature of the trading strategy implies that it remains a wildcard for investors, especially during periods of heightened market volatility.
In conclusion, the ramifications of the carry trade strategy on global markets are far-reaching, exemplifying how interconnected the financial world is. Investors must remain vigilant and adaptable to navigate the uncertainties that can arise from such trading practices.
