What is a Yen Carry Trade?
A Yen carry trade involves borrowing money in Japanese Yen (JPY), which typically has low-interest rates and a weak currency. Hedge funds and other investors take advantage of this by borrowing in Yen, then selling the Yen to buy other currencies. With these proceeds, they invest in various risky assets such as commodities, equities, and bonds.
The idea is simple: as long as the Yen depreciates or remains stable and interest rates in Japan stay low, the carry trade can be highly profitable. Investors not only earn returns from the invested assets but also benefit from the weak Yen, making their borrowed funds cheaper in real terms. This strategy can amplify both the weakness in the Yen and the strength in the asset classes being invested in as more traders participate.
What Happens During the Unwinding of a Carry Trade?
The carry trade is highly sensitive to changes in the currency and interest rate environment. When the Japanese Yen starts to appreciate, the carry trade becomes less profitable. Hedge funds and retail traders who have engaged in the carry trade begin to cut their losses by reversing their trades—they sell the assets they invested in and buy back Yen to repay their loans.
This increase in demand for Yen drives its value higher, creating a self-reinforcing cycle where the rising Yen leads to more unwinding of carry trades. Consequently, the prices of risky assets fall sharply. This process can create a domino effect, leading to a significant decline in risky assets and a substantial rise in the Yen.
Current Trends in Commodities
Recently, Japanese domestic traders have been buying gold, silver, copper, and foreign equities to protect against a very weak Yen. The Yen had depreciated by nearly 16% against the USD this year before it peaked near 162 in USD/JPY terms. This depreciation made the Yen carry trade particularly attractive. Hedge funds have likely taken advantage of this by engaging in Yen carry trades.
However, the sharp rise in the Yen over the past 10 days may have triggered unwinding from these traders. As the Yen strengthens, traders are forced to liquidate their positions in commodities and other risky assets to cover their Yen borrowings, further amplifying the upward pressure on the Yen.
The Bigger Picture: Global Implications
Monitoring the USD/JPY exchange rate is crucial if you are trading commodities. Movements in this currency pair can significantly impact the performance of commodities. Currently, we have a hawkish Bank of Japan, which is positive for JPY, and on the other hand, dovish stances from the ECB, BOE, and US Fed, which are negative for their respective currencies.
This scenario creates a double whammy for traders who funded their long bets in risk assets across major geographies, including emerging and developed markets, via shorting JPY. The rising JPY is triggering unwinding of these trades, leading to further liquidation—a domino effect. Commodities are also caught up in this unwind. Adding to this is the spiraling downward trend of the Chinese economy and concerns over the US jobs market, which have hit risk traders hard.
Historically, since 1990, whenever Japan considered policy normalization, massive global crises erupted, pulling Japan back into another decade of monetary easing and money printing. This historical context underscores the potential volatility and far-reaching implications of changes in the Yen carry trade.
Conclusion
In the short term, keeping an eye on the USD/JPY exchange rate is crucial for anyone involved in trading commodities or other risky assets. The interplay between a hawkish Bank of Japan and dovish central banks elsewhere creates a complex environment where the Yen carry trade can rapidly unwind, leading to significant market movements.
As the Yen carry trade unwinds, we may witness sharp drops in USD/JPY, equities, bullion, and energy prices. US jobs data could further exacerbate this trend, triggering additional Yen carry unwind as US rate cut bets soar.
The unfolding dynamics of the Yen carry trade serve as a reminder of the interconnectedness of global financial markets and the importance of being prepared for sudden shifts. While we hope for a different outcome this time, the potential for market upheaval remains high, promising both challenges and opportunities for astute traders.