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A carry trade is when you borrow money and use it to make another investment that you believe will be more profitable than the costs associated with borrowing. In the case of the Japanese yen carry trade, participants with the intention of investing in the U.S. will borrow money at low interest rates in Japan, convert the local currency (yen) to U.S. dollars, then invest those dollars in an asset or assets in the United States they believe will earn more than the cost of the loan in Japan. Assuming currency exchange rates are stable, the math is really quite simple. If interest on a Japanese loan is 2% and a safe U.S. government bond can get you 4%, that’s an easy 2% profit on somebody else’s money. The more you can borrow, the more profit, or in this case free money, you can make. What makes this transaction even more profitable is when the currency you’re borrowing depreciates over time relative to the currency you’re investing with. When this happens, at the end of the trade when dollars are converted back into yen, you get far more yen than you originally started with because of the strong dollar/weak yen relationship.

However, and this is the problem, if that currency relationship starts moving in the wrong direction, those easy profits can turn to losses very quickly on money that isn’t yours. In the case of that easy 2% profit in a stable currency scenario, an annual yen strengthening of just 2% relative to the dollar would wipe out that entire gain from the treasury bond investment. If that 2% currency fluctuation happens over the course of weeks or months, then losses materialize much more quickly. An aggressive carry trade investor may try to hedge some of that currency risk by seeking U.S. investments with much higher return prospects, such as, let’s say, Nvidia shares. If the stock continues to rise parabolically like it has, then there’s almost no amount of dollar weakening/yen strengthening that could wipe out those gains upon trade unwind and conversion back to yen. This trade in effect, is no different than any other margin trade. When Nvidia stops going up, and eventually comes back down to earth, losses will be much greater than in any scenario using a more stable treasury bond investment.

Should we worry about the yen carry trade impacting markets? Not really. We consider the carry trade, which is estimated to be worth more than 4 Trillion dollars, one of many potential factors that could lead to a large valuation unwind in U.S. markets. If the yen strengthens meaningfully against the dollar, carry traders would likely be motivated to sell assets, which depending on other factors, could steer market direction. More likely however, is that we see a confluence of factors dictate market direction (some known, others unknown), and that downward move in markets would probably lead to many excesses being unwound concurrently, the yen carry trade being one of them. It’s never just one thing we should be concerned about, but rather the convergence of many. Add this one to the list.


Editor’s Note: This article was originally published in the September 2024 edition of our “Cadence Clips” newsletter.

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