How did the Yen Carry Trade cause last week's crash?

Last week, fear gripped the markets, leading to a major sell-off across all asset classes. But why did this happen?

Several factors contributed, including global unrest with various countries experiencing riots, concerns about a potential World War III outbreak, and fears of a U.S. recession as Kamala Harris gains traction in the polls. However, the most significant factor was the Yen Carry Trade phenomenon.

What is the Yen Carry Trade?

A Carry Trade occurs when people borrow money where it’s cheap, convert it into another currency, and invest in assets using that currency. In this case, Japan offered very cheap capital, and a lot of people borrowed Yen and converted it into Dollars to invest.

Following the economic turmoil and inflation caused by the COVID-19 crash, the UK, EU, and US all sharply increased interest rates (see Image 1), raising the cost of borrowing. However, since economic activity tends to decrease when borrowing costs rise because people can no longer borrow cheaply, Japan kept its interest rates low to keep its struggling economy afloat.

This created an opportunity for individuals and organisations to exploit the situation:

1. Borrow Yen in Japan: Where it’s cheap to borrow.

2. Convert the Yen to USD: To trade with it.

3. Buy Yield-Generating Assets: Such as the S&P 500 or bonds, and yield.

4. Convert USD Back to Yen: To repay the debt.

5. Profit: From the difference.

Above (Image 2) you can see an example of how this scenario plays out on a smaller scale. Now imagine many institutions, wealthy individuals, organisations, and other entities doing this on a much larger scale; some estimate it to be $1.1 Tn, others at $500 Bn.

This creates what many thought was an infinite money glitch as long as the borrowing conditions remain favourable.

The Breakdown of the Yen Carry Trade

On July 31st, Japan raised its borrowing rate to 0.25%. While this might seem like a minor adjustment, it disrupted the "infinite money glitch" created by the Yen Carry Trade because entities needed to liquidate some of their positions to pay back their loans.

Since investors need to pay back the loans in Yen, they need to sell Dollars to buy Yen, appreciating it against the USD, which makes the debt even more expensive.

For example, if someone borrowed 1 million Yen at the start of July, it would now cost $7,700 to buy back that Yen, resulting in a $450 loss (Image 3).

And as shown in Image 4, the Yen’s performance against the USD improved significantly last month, from $0.0062 to $0.0069 per Yen (11% increase since 10th July).

The final issue occurs when yield-bearing assets, like stocks, stop appreciating. On August 2nd, $2.9 trillion was wiped out from stocks due to fears of a global recession, marking the worst day in the stock market since the 2020 COVID crash.

This triggered a spiral: everyone who borrowed Yen panicked, selling off their assets, causing further price drops. They then bought back Yen to repay loans, pushing Yen prices even higher, and forcing more liquidations. As a result, the Yen Carry Trade strategy unravelled, contributing significantly to the worst day in the stock market since 2020.

So whilst other factors played a role in the breakdown of the stock market, the breakdown of the Yen carry trade exacerbated this sell-off.

Why Did Japan Raise Interest Rates?

The Japanese economy has been struggling, with the Yen continuously weakening due to the Yen Carry Trade - as a net importer, this proved particularly costly for its citizens. Additionally, Japan is heavily indebted and must make continuous repayments. Japan is often seen as the “Canary in the Coal Mine,” signalling broader economic issues.

The surprise rate hike was a last-ditch effort to prevent the Yen from collapsing.

Implications of Japan's Interest Rate Hike

1. Reduced Government Spending: Japan will have less money available for government spending.

2. Impact on U.S. Treasuries: Japan is one of the largest buyers of U.S. Treasuries. If Japan can no longer afford U.S. Treasury bonds, the U.S. may struggle to sell them, potentially forcing the Fed to print money to purchase government bonds.

3. Continued Stock Market Volatility: The stock market sell-off may continue, with reduced global demand for assets as the Yen Carry Trade breaks down. As borrowing costs rise, more people may choose to save rather than invest.