This isn’t as important as the Olympics, but some pals have been asking me, “What is the yen carry trade?” and " Why did it affect world equity and currency markets so dramatically last week?”
So I’ve answered with: As far as the eye can see, investors (defined here as the world’s largest financial institutions (i.e. JPMorgan, Deutsche Bank, Goldman Sachs, Mitsubishi Mistui, Citadel, and your professional money manager, right?) have been able to borrow the yen at no cost (Bank of Japan overnight lending rate is/was 0%), then sell that borrowed yen for dollars and invest those dollars in the U.S. government securities market earning +4%.
You know, 4% is pretty good, but not great. Why not invest some of those dollars in say, Microsoft, which pays only a 3/4% dividend – but it’s Microsoft, you get the cloud and AI for free! Or, hey, why not buy Toyota Motors?
It’s in Japan, it pays a 4% dividend, and every American owns a Corolla. Everyone from Daddy Warbucks to Scrooge McDuck (except your professional money manager) has been doing all the above in size for years for massive profits.
No one knows the size of the yen carry trade, but the Bank of Japan reports that total foreign borrowing from Japanese Banks is over $1 trillion. I mean, why not? What could go wrong?
Okay, stay with me now. This is simple but complicated and easier to say than to write.
The success of this yen carry trade is predicated on 1. The cost of the yen you sold stays constant or drops versus the dollar, and 2. The interest rate you pay for borrowing the yen is not increasing.
Well, since mid-July, No. 1 has not been cooperating as the yen has appreciated roughly 10% vs the dollar.
Hmm, I’m earning 4% a year on my U.S. treasuries, but I just lost 10% in two weeks on the yen I have to buy back ... ouch!
Then, on Monday, the BoJ raised overnight interest rates. So, borrowing in Japan is no longer free ... another ouch. Remember, this trade’s size is huge (“the path is wide”), and the investors want to go out now (but the gate is narrow).
Getting out of this trade might be harder than getting into heaven. To unwind the yen carry trade, investors must: 1. Sell their investment in treasuries and/ or Microsoft for dollars, then 2. Sell these dollars to buy back the yen they sold, and then 3. Sell these dollars so they can return the yen they borrowed. And everyone wanted to do that on Monday, which helped Japanese equities collapse 12% and US equities slip 4%.
“I’ll give you back the cheese just, please, let me out of the trap.”
Like I said, it’s simple but complicated.