This article takes an in-depth look at the carry trade, a popular investment strategy that takes advantage of global interest rate differences, allowing investors to borrow in low-rate currencies and invest in higher-yielding ones. This strategy, especially prominent in foreign exchange markets, has shown significant effects on global finance, particularly when it comes to the Japanese yen. The yen’s consistently low interest rate has made it a favored borrowing currency, impacting asset flows and currency valuations worldwide. However, the strategy carries risks, especially as currency fluctuations and central bank policies can quickly change the profitability landscape. This was especially demonstrated in the events that unfolded during the summer, as the yen carry trade experienced a sharp unwinding of positions following a raise in short term interest rates by the Bank of Japan (BoJ). Using the dynamics of the yen carry trade, this article will provide a look into how carry trades work, the factors that determine the strategy, and its broader effects on global markets.

​The Basics of Carry Trade

A “Carry Trade” is an investment strategy that entails borrowing capital at a low interest rate to invest in assets with a potentially higher return. Commonly used in the forex market, this strategy involves borrowing a currency from a central bank at a low interest rate and reinvesting it into a different currency with a higher yield. The profit formula is shown below:

From the formula, we can conclude that the primary risk in a carry trade comes from the volatility of the exchange rate at the time when the position is closed (E1). Another potential risk is the narrowing of the spread between the higher-yielding currency (i quote) and the lower-yielding currency (i base) over the holding period (d). A smaller spread would lower the expected profit, as the return in a carry trade largely depends on the difference between the interest rates of the two currencies.
The yen carry trade has been a key driving force in financial markets, especially during the late 1990s and early 2000s. At that time, Japan maintained exceptionally low rates while economies like the US and Europe experienced higher rates compared to their historical average. History reveals several instances where the yen carry trade impacted global markets, notably in 2008 during the sub-prime mortgage crisis. Foreign banks were initially borrowing yen at low interest rates to invest in higher-yielding assets abroad. As the crisis approached, these banks saw a surge in yen-denominated liabilities, leading them to accumulate more yen liabilities than assets, effectively creating a net short position on the yen. When the crisis intensified, banks began unwinding these trades to reduce their exposure.

Consumer Price Index - Japan

Since the late 1990s, Japan has had to address an unusual problem: deflation. Deflation discourages investments and renders economic growth harder to achieve. In order to incentivize loans (therefore investments) and input more liquidity in the economy, the Bank of Japan (BoJ) has often kept negative interest rates. Additionally, Japan faces persistent economic challenges, including stagnant GDP growth due to an aging population, which reduces workforce productivity and demand. These factors reinforce the need for a low-rate monetary policy. Recently Japan’s monetary policy has been focused on maintaining a 2% consumer price index (CPI) increase per year, in order to keep overall prices stable and enabling its central bank to maintain low interest rates.

US Interest Rate (%)

Japan Interest Rate (%)

In contrast, other central banks, like the ECB and the Fed, have taken a stricter approach to interest rates policies, especially in the post-pandemic period. Both currently have rates above the 4% mark. The BoJ’s exceptionally low interest rates, compared to other central banks, make the yen carry trade a highly desirable opportunity.

Historical Global Impact and Lessons Learned

​As previously mentioned, there are several instances where the yen carry trade has significantly impacted global markets. One of the earliest notable episodes occurred in 1998, when the JPY/USD exchange rate experienced unprecedented volatility. This volatility can be largely attributed to a substantial unwinding of short-yen positions. As the market conditions changed, investors were forced to buy back yen to cover these positions, which led to an appreciation of the currency. Market sentiment and impulsive trading, particularly by major hedge funds, further influenced currency movements, intensifying the volatility of the exchange rate. The collapse of the yen carry trade contributed to the global market instability. This event highlights the ripple effect among investors, which can heighten the consequences of changing interest rates and amplify the volatility related to carry trades. These findings emphasize the need to consider both macroeconomic factors and investor behavior in understanding currency movements dynamics, particularly in relation to the yen carry trade. 
 
The yen carry trade also played a role in worsening the 2008 U.S. credit crunch, driven by its reliance on global credit conditions and interest rate differentials. Prior to the crisis, during the 2006-2007 period, the yen carry trade became increasingly popular as investors sought higher returns in other currencies, especially in higher yielding assets. This context of low volatility and strong market sentiment led to a significant flow of capital into riskier assets. The yen was used to fund U.S. investments, contributing to the growth of financial intermediaries’ balance sheets, particularly among highly leveraged U.S. broker-dealers. As the credit crisis began, investors and institutions aimed to decrease their exposure to deteriorating U.S. assets, namely to subprime mortgages. Given that U.S. assets were losing value, the yen began to appreciate significantly against the U.S. dollar, impacting the yen carry trade and causing investors to unwind their positions to mitigate their losses. This led to a surge in the yen’s value combined with a loss of value for U.S. broker-dealer assets. The USD/JPY pair lost nearly 30%, leading to massive liquidation and market chaos.  This shift reflected financial deleveraging as liquidity contracted across global markets, which intensified financial instability during the crisis. This instance illustrates how the popularity of the carry trade could inflate the balance sheets of institutions and hedge funds, amplifying risk appetite for other financial assets. In the case of the financial crisis of 2008, this risk appetite affected the markets beyond currency trading, intensifying global financial instability. 
Other currencies, like the Icelandic Krona (ISK), also experienced an impact during the 2008 crisis given its high interest rates at the time. After borrowing low-interest rate currencies such as the JPY, investors would reinvest in higher yielding Icelandic assets. As the financial crisis unfolded, investors rushed to unwind their carry trades leading to a depreciation of the ISK, which caused substantial losses and worsened the volatility of the currency. This instance highlights the potential consequences of carry trades for economies with high interest rates. The recent developments undoubtedly decreased confidence in the stability of the yen carry trade. These fluctuations can be compared to the dynamics observed in other carry trades, such as the Swiss Franc (CHF), another popular carry trade currency. The CHF has kept historically low interest rates, even during the global inflation period of 2022-2023. Currently, the Swiss National Bank is pushing for a disinflation process, implementing cooperative policies, and cutting rates. This could imply that the CHF carry trade may offer a more favorable carry trade environment than the yen carry trade. 
 
Several lessons can be learnt when analyzing the yen carry trade’s historical impact. For instance, the 1998 volatility increase highlights the importance of considering investor behavior as well as macroeconomic factors. On the other hand, the financial crisis of 2008 demonstrated the extent to which the yen carry trade could have broader implications for global financial markets, expanding beyond a currency trade. Although significant, evidence suggests that the recent unwinding of the yen carry trade resulting from the increase in interest rates by the BoJ is not as alarming as previous historical episodes related to the latter. This recent activity reflects the current state of financial fragility we are experiencing, driven by increased volatility and unstable interest rates across the globe. This environment of uncertainty and shifting monetary policies creates risks that could potentially impact investor behavior and market stability, highlighting the need for caution and monitoring of these developments in the future.

Impact on Global Financial Markets and BoJ Policy

The carry trade is an investment strategy that can be potentially lucrative, however as Japan experienced in August 2024, it can trigger widespread market disruptions, becoming significantly risky. The strategy impacts global financial markets mainly in terms of asset prices and exchange rates, risk appetite, and market volatility. 
By borrowing a currency at low rates and funding high-yielding investments in foreign countries (e.g. emerging market currencies, high-yield bonds, and stocks in high-growth regions), the demand for such assets tends to increase, thus resulting in price appreciation. In the specific context of Japan and the yen carry trade, the securities that traditionally have attracted considerable flows are the AUD, NZD, and MXN, and asset classes such as Taiwanese equities and U.S. tech stocks. Therefore, the strategy affects capital flows and price dynamics not only in the lending country but across global markets, exposing investors to interest rates changes, exchange rates risks and devaluation risks. 
Furthermore, the strategy alters market participants’ risk appetite and is particularly sensitive to market sentiment shifts. The low borrowing costs amplify risk-taking behaviors and modify investors preferences, encouraging traders to pursue speculative and riskier opportunities. Hence, the willingness to take on risk increases, and as the market becomes crowded with investors taking similar, riskier positions, shifts in sentiment can become very dangerous. 
Finally, escalating market volatility is a direct consequence of the borrowing trade. Since the trade relies heavily on the stability of the lending currency and steady domestic interest rates, any unexpected event can worsen the volatility of the domestic market as well as the overall global economy. For instance, a sudden hawkish monetary policy stance by the BoJ, as the one experienced during the summer, or adverse economic developments elsewhere (e.g. dovish Fed policy or escalating geopolitical tensions in Middle East and Eastern Europe) can trigger the liquidation of positions causing sharp currency fluctuations, namely the unwinding of positions. Subsequently, the effects can extend to international investors (i.e. domino or ripple effect) where shockwaves in prices are generated by the rapid widespread sell-off of previously robust assets.
 
Having analyzed the effects of the carry trade on global financial markets, it becomes clear that the ongoing role of the Bank of Japan has played and continues to play a central role in the trade’s dynamics. As a matter of fact, the shifts in the BoJ’s stance since March have strongly impacted the trade, resulting in a global unwinding throughout the summer, especially in August, followed by a recent reopening of positions since early October. Historically, the BoJ's accommodative stance has bolstered hundreds of billions of dollars invested in the carry strategy—around $500bn since 2011, according to UBS strategist James Malcolm, and around $20tn overall, according to DB’s head of currency research, George Saravelos. However, the interest rate hikes of 20 bp in March and 15 bp in July, alongside with the Fed’s dovish stance, have strengthened the yen, narrowing the yield gap and threatening the strategy’s viability, thus resulting in the liquidation of around $200bn and a 12% fall in the Nikkei 225 index and 3% in the S&P 500. Yet, speculative bets on the yen have recently resurged following dovish announcements from Japan’s new PM, Shigeru Ishiba. The intent to avoid further rate hikes has encouraged rebuilding short positions on the yen, strengthened by BoJ policymaker Seiji Adachi's remarks suggesting that gradual rate increases aren't even likely until the end of 2024. Having understood the importance of potential shifts in the BoJ or Fed policy and geopolitical dynamics on global markets, the following paragraph will delve into the effects of such changes and explore possible hedging strategies to protect investors from the risks involved in the yen carry trade.

Impact of Policy Changes, Inflation, and Geopolitical Events

Carry trades are particularly vulnerable to policy changes, as seen in the sudden change by the Bank of Japan, volatility, and geopolitical events, which may appear unimportant but can raise volatility and reduce profits from the trade. Unexpected events can shift currency values and interest rate expectations, leading to changes in carry trade positions. Moreover, geopolitical events affect countries differently, depending on their economic and political environment. These risks may reduce returns and can trigger the unwinding of positions by traders. Finally, sudden shifts in monetary policy from central banks greatly impact the carry trade. Carry trades strongly depend on the interest rate differential between the two currencies, so a decision to change the level of interest rates may result, as in the case of the yen, in an unwinding of investor positions in the trade. To protect against such losses, investors may resort to hedging strategies like purchasing options in the foreign exchange market and portfolio diversification, which both provide a way to preserve profit opportunities and manage the carry trade’s volatility. By allocating investments across various asset classes and currencies, investors can minimize exposure to any single market or economic event.  One effective hedging method is an options strategy called risk reversal, which involves buying a yen call option and financing it by selling a yen put option. This strategy is particularly popular because it allows investors to profit from the appreciation of the yen reducing the risk of the carry trade.
 
Another factor to consider when assessing risks in the carry trade is inflation, which has a complex relationship with this strategy. Higher inflation can lead to a depreciation of the currency as the purchasing power of that currency diminishes. Central banks respond to inflation with tightening monetary policy, leading to a rise in interest rates. As mentioned above, these rate hikes can reduce the interest rate differential, one of the main drivers of the carry trade, and therefore reduce its profitability. This is the main reason for the turmoil seen after the Bank of Japan’s decision to raise interest rates and the anticipation of rate cuts by the Fed. High inflation may also be a symptom of economic and political instability, which can weaken investor sentiment and make investments less appealing. Investors, therefore, should consider inflation and central banks’ policies when assessing the profitability of the trade.
 
Market participants have responded differently to the recent development of the yen carry trade. Hedge funds, for instance, have shifted to net long positions in the yen, marking the highest levels in the last eight years. Japanese institutional investors, like public funds and insurance companies, who hold around $2.5 trillion in U.S. securities, accounting for almost 10% of the value of foreign holdings of U.S. securities, may decide to move their investments back to Japan or hedge their overseas exposure, which could strengthen the yen in the medium to long term. It will be interesting to see how future developments, particularly policy shifts from the BoJ and the Fed, impact the trajectory of the yen and the carry trade strategy for investors. With dovish signals from Japan’s new PM and BoJ policymakers suggesting no rate hikes until 2024, the market's response will determine if speculative positions continue or if they will face disruptions.

Conclusion

This article has shown that the carry trade’s influence on global finance is profound, affecting currency movements, capital flows, and market volatility. History has shown that the yen carry trade has often amplified instability during financial crises, such as in 1998 and 2008, highlighting the delicate balance required to manage these speculative strategies. Recently, shifts in the Bank of Japan’s policies have altered the appeal of the yen as an attractive currency for carry trades, sparking new considerations for international investors. Given the risks, strategies like hedging and diversification are becoming increasingly important for investors looking to navigate the complexities of carry trades in today’s unpredictable financial landscape. Ultimately, as inflationary pressures prompt central banks worldwide to reassess their rate strategies, the future of carry trades will largely depend on these monetary policy shifts and the broader market sentiment.

By Francesca Dini, Annaelle Pater, Giacomo Ferrante, Jacopo Bianchini

​SOURCES:

• Financial Times
• Reuters
• Bank for International Settlements
• Japan Times
• Yahoo Finance
• Investopedia
• Science Direct
• Economic Systems, Volume 47, Issue 2
• Amundi Asset Management
• JP Morgan
• International Monetary Fund
• Journal of International Money and Finance
• Hedge Week