Yen Carry Trade Explained:
What Is It and Why Does It Matter?
What the yen carry trade is, why investors use it, and how an unwind can hit stocks, crypto, and other markets
THE CARRY TRADE
We keep hearing about the yen carry trade at the moment…
Carry trade this.
Carry trade unwind that.
And I thought it was worth actually breaking it down in simple terms so we can work out how it might affect us.
Not pretending to be some macro genius here… just what the hell is it, why does it matter, and why are traders keeping an eye on it?
So… Let’s start with the idea…
Borrow cheap, earn more.
Let’s imagine our mate Dave lends us £100,000 and charges us 1% interest.
(Cheers, Dave
)
And then we lend that £100,000 to Steve at 5% interest…
We’re paying Dave 1%, collecting 5% from Steve and pocketing the 4% difference.
Nice work if you can get it…
That’s basically the idea behind a carry trade.
And actually, very loosely, it’s not a million miles away from what banks do.
They take deposits from savers, pay them one rate, then lend money out through mortgages, loans, etc at a higher rate.
(Obviously there’s a bit more to running a bank than that…)
But you get the idea.
So why Japan?
Japan has had extremely low interest rates for years.
Japan is basically Dave…
Traders and institutions could borrow cheaply in Japanese yen, convert that money into another currency and put it somewhere offering a higher return. (Our mate Steve.)
That could be something relatively straightforward like higher-yielding government bonds.
Or the money could end up in equities, the Nasdaq, crypto… or a mixture of different assets.
The basic idea is the same…
- Borrow cheap money in yen
- Put that capital somewhere we think we’ll earn more.
Keep the difference.
Again… nice work.
Then the yen moves…
And this is where things get, shall we say… ‘interesting’
So, let’s say our interest rate difference means we’re expecting to make 4% over the year.
Nice return. Especially on the sort of size the institutions trade…
But then the yen strengthens 4% against the currency we’re holding.
And poof, there goes our entire year’s carry.
And that FX move doesn’t have to take a year, right? It can happen in a week or two.
Which is pretty much the problem…
Erm, now we need cash.
Because these positions can be leveraged.
If the yen keeps strengthening against us, we’re not just watching our nice little interest rate profit disappear…oh no…we could also be getting margin calls.
Which means we need cash. And fast…
And where do we get that cash?
Well… we might have to start selling those other assets we bought.
Equities. Bonds. Crypto. Trump coin…. Whatever else we’re holding.
So suddenly a move in the yen is causing selling somewhere that, on the face of it, has absolutely f all to do with Japan.
And then everyone starts to wonder.
Ah but wait… there’s another potential layer to this.
If things start getting messy, the banks and institutions providing some of this funding are going to start paying a bit more attention to who they’re exposed to.
Are they good for it?
How leveraged are they?
What happens if markets keep moving against them?
Potential counterparty risk starts creeping into the conversation.
And you can see how something that started off sounding pretty harmless…
Borrow at 1%. Earn 5%. Pocket 4%. Lovely jubilee…
…can potentially turn into a bit of a nightmare when everyone starts heading for the exit at once.
In theory, everyone is running out of the same small door.
Selling assets and buying yen.
So what happens? The yen strengthens, which applies yet more pressure on the carry trade, which creates more margin calls.
Potentially more selling.
And around we go… are we having fun yet?!
What does that mean for us traders?
Does all this mean some enormous carry trade unwind is about to smash the markets?
Honestly? No idea.
Maybe it does.
Maybe it doesn’t.
But if we start seeing the yen strengthening quickly, particularly alongside weakness in equities and other risk assets, we now understand why people start paying attention, and the press goes on about the carry trade unwind.
There could be leveraged money being unwound somewhere in the background.
And if that starts forcing people to sell assets to raise cash, those moves can feed on themselves pretty quickly.
But no one really knows what the true extent of the positioning is.
And all of this doesn’t mean we suddenly need to become yen traders or start pretending we’re macro experts…
But it does mean USDJPY is probably worth having somewhere on the radar when markets start getting a bit wobbly.
Because if we hear someone say “the yen carry trade is unwinding” while the Nasdaq is getting battered…
At least we can nod knowingly at the screen rather than wondering what the bloody hell they’re talking about.
Which is handy, right?