Interview, Other
How a popular trade collapsed — and why it matters
- The yen carry trade involves borrowing in a low-yielding currency (historically the Japanese yen at ~0%) to invest in higher-yielding currencies (e.g., US dollars at ~5% or Mexican pesos at ~10%).
- The strategy relies on two profit sources: the interest rate differential ("carry") and capital appreciation of the high-yield currency against the low-yield funder currency.
- The spread between Japanese borrowing costs and US investment yields reached nearly 5 percentage points post-pandemic, with emerging market spreads (e.g., Mexico vs. Japan) reaching 9–10%.
- Yen carry trades proliferated significantly starting in 2016 following Japan's introduction of negative interest rates, with a second wave accelerating in 2023 due to strong risk-adjusted returns.
- Market positioning reached extreme levels in July 2024, with Goldman Sachs data indicating record yen shorts and speculative positioning driving the trade to historical highs.
- Institutional investors in Japan, specifically pension funds and investment trusts, increasingly held foreign assets unhedged; currency hedge ratios for these funds dropped to multi-year lows of approximately 45%, down from a historical norm of ~60%.
- The unwind was triggered by a narrowing of the interest rate differential caused by the Bank of Japan's surprise rate hike in July and market pricing in faster US Federal Reserve cuts following weak US employment data.
- Speculative flows (hedge funds and CTAs) have largely unwound their yen short positions, returning to flat levels, according to recent positioning data.
- Institutional flows, comprising approximately $2 trillion in foreign bond holdings and $1 trillion in equity holdings by Japanese investors, remain stickier and the extent of further unwinding is uncertain.
- A negative feedback loop driven by Value-at-Risk (VaR) models forced widespread liquidation across unrelated assets, as drawdowns in yen-funded positions triggered mandatory risk reductions in multi-manager funds.
- Japanese retail investors likely faced margin calls during the initial yen appreciation, whereas institutional unwinding is expected to be a slower process driven by currency hedging rebalancing or asset repatriation.
- The trade is not expected to end permanently; however, re-engagement is currently hindered by elevated implied volatility in the yen, which may not normalize until mid-November post-US election.
- Goldman Sachs economists note that if the US avoids recession, the fundamental yield differential remains attractive enough to potentially restore the trade, contingent on US growth data and US employment reports in September.
- The recent equity market volatility is attributed to a "perfect storm" of factors rather than the carry trade alone, including disappointing earnings, AI sector concerns, and coincidental weak US data, though the yen unwind contributed to spillovers in Latin American currencies and the Chinese renminbi.
- The episode highlighted increased market brittleness due to endogeneity, where concentrated positions funded in a single currency created a vicious cycle of correlated liquidations, distinct from the exogenous shock dynamics seen in 2020.
- Investors may pivot to alternative funding currencies with low rates, such as the Chinese renminbi, if the Japanese case for lower rates strengthens relative to the global hiking cycle.