FX International Payments
By Bill Camarda
A decade later, the yen carry trade appears to be undergoing a revival, as the interest rate spreads between the U.S. and Japan are widening again. It's worth considering the yen carry trade's role in the Great Recession, why it happened, and any lessons that emerge from that episode of economic history.
Carry trades involve borrowing in currencies with low interest rates and investing the proceeds in currencies where interest rates are higher, thereby earning relatively easy profits.2 The "Law of One Price" economic theory predicts that the profit opportunities from price differences of this kind should quickly disappear, as arbitrage rebalances the prices of assets across markets.3 But carry trade opportunities have often lingered, offering sustained opportunities for profit, and a growing body of academic research now helps to explain that persistence.4
For nearly two decades before the global financial crisis, the yen-dollar carry trade was often among the most prominent carry trades. It grew because the Bank of Japan kept interest rates extremely low from the mid-1990s onward in an attempt to reignite Japan's stagnant economy,5 while the U.S. Federal Reserve generally maintained higher interest rates. The spread between Japanese and U.S. interest rates encouraged many foreign exchange traders to sell yen they had borrowed at low rates and buy dollars they could lend at higher rates.6
When the Fed started to raise interest rates in the mid-2000s, the widening spread between U.S. and Japanese rates triggered a sudden increase in the yen-dollar carry trade.7 The trade grew rapidly in the run-up to the global financial crisis, as even individual currency traders joined hedge funds, banks, and other financial institutions in pursuit of higher returns.8
From 2004-2007, rapid growth in yen carry trades made far more dollars available for investment in the U.S. While some of this money was invested in U.S. Treasury bonds, much of it found its way into higher-yielding assets such as collateralized debt obligations (CDOs) and U.S. subprime residential mortgage backed securities (RMBS) – assets whose prices collapsed in 2007-8.9
As the bubble burst and the Great Recession began, the Fed dropped interest rates precipitously, eliminating the differences in rates between Japan and the U.S.; the basis for the yen carry trade disappeared.10 Yen carry trades quickly unwound, reducing dollar liquidity. Japanese investors, and yen-leveraged American and European investors, sold RMBSes, CDOs and other diverse assets and debt, purchasing dollars which they then sold for yen. This contributed to the collapse of those assets' prices, which in turn added to an extraordinary demand for dollars. The Fed responded by undertaking aggressive quantitative easing – i.e., pouring new dollars into the economy.11
The yen carry trade had worked when the yen-dollar exchange rate was relatively stable, or when the yen declined against the dollar – as it did by roughly 20 percent from 2004-2008. But in the wake of Lehman Brothers' September 2008 collapse, the yen rose rapidly along with USD while most other currencies fell by comparison. Japanese investors sold risky dollar-denominated assets and bought yen with the proceeds, pushing the yen up vs. the dollar. American investors who had borrowed in cheaper yen to fund dollar-denominated investments faced rising FX costs in carrying their yen loans. They rushed to sell dollars (and other currencies) to buy yen they could use to repay their yen loans, pushing the yen exchange rate even higher. These events contributed significantly to the volatility then roiling currency markets.12,13
A few years after the global financial crisis, Japan's expansionary economic policies contributed to a re-emergence of the yen carry trade, as the yen's value dropped by 26 percent and significant differences between U.S. and Japanese interest rates reappeared.14 Yen carry trades increased by 70 percent between 2010 and 2013.15 However, by early 2018, yen carry trade strategies had racked up four straight quarters of losses. The outlook for the yen carry trade seemed poor: the yen was rising against other currencies, traders expected the Bank of Japan to tighten the reins on economic growth and raise interest rates, and traders anticipated higher volatility in connection with growing international trade frictions.16
But in August 2018, the Bank of Japan announced that it would keep interest rates extremely low for an indefinite period. Observers noted that the Fed had already raised interest rates several times, and was projecting five rate hikes through the end of 2019.17 Meanwhile, in the second quarter of 2018, Bloomberg found borrowing yen to purchase dollar assets earned investors an exceptionally attractive return of 4.9 percent, taking into account fluctuations in exchange rates, levels of interest, and the funding costs.18
It isn't yet clear how long the recent revival of the yen carry trade will be sustained. Historically, the yen has often been viewed as a safe haven currency. If increased volatility drives FX traders to safety, the yen's value could rise, making the carry trade less profitable.
But if the yen carry trade does keep growing, it could again impact exchange and interest rates.19 When spreads between interest rates widen, traders inevitably seek to take advantage of them. The experience of 2007-2008 teaches that this can lead to market distortions and even bubbles.
Ten years after the yen carry trade contributed to the global financial crisis, it appears to be returning as a strategy for traders seeking to profit from interest rate spreads and exchange rate differences between Japan and the U.S.
Bill Camarda is a professional writer with more than 30 years’ experience focusing on business and technology. He is author or co-author of 19 books on information technology and has written for clients including American Express Private Bank, Ernst & Young, Financial Times Knowledge and IBM.
1. “Is the carry trade coming back from the dead?,” TheBull.Au; http://www.thebull.com.au/experts/a/5976-is-the-carry-trade-coming-back-from-the-dead.html
2. “Briefing: The Return of Carry,” IPE; https://www.ipe.com/investment/briefing-investment/briefing-the-return-of-carry/www.ipe.com/investment/briefing-investment/briefing-the-return-of-carry/10022500.fullarticle
3. “Why Is Arbitrage Trading Legal?,” Investopedia; https://www.investopedia.com/articles/investing/032615/why-arbitrage-trading-legal.asp
4. “Why exploiting the 'carry trade' seems to work,” MoneyWatch; https://www.cbsnews.com/news/why-exploiting-the-carry-trade-seems-to-work/
5. “Prospects for the yen carry trade,” Breugel; http://bruegel.org/2012/02/prospects-for-the-yen-carry-trade/
6. “Japan’s fearless women speculators,” Financial Times; https://www.ft.com/content/6c1a6eb2-fc8b-11dd-aed8-000077b07658 (registration required)
7. “Yen Carry Trade and the Subprime Crisis,” International Monetary Fund; https://link.springer.com/article/10.1057/imfsp.2009.2
8. “Japan’s fearless women speculators,” Financial Times; https://www.ft.com/content/6c1a6eb2-fc8b-11dd-aed8-000077b07658 (registration required)
10. “How Carry Trades Made the Financial Crisis Worse,” MarketMogul; https://themarketmogul.com/how-carry-trade-made-the-financial-crisis-worse/
12. “Yen Carry Trade Explained with Its Pros, Cons, and How It Is Today,” The Balance; https://www.thebalance.com/yen-carry-trade-explained-pros-cons-how-it-is-today-3305971
13. “Yen carry trade unwinding,” Economics Help; https://www.economicshelp.org/blog/glossary/yen-carry-trade-unwind/
14. “Yen to slip over next year on carry trades, BOJ stimulus,” Reuters; https://www.reuters.com/article/us-markets-forex-poll-yen-idUSBRE9A50SG20131106
15. “Yen Carry Trade Explained with Its Pros, Cons, and How It Is Today,” The Balance; https://www.thebalance.com/yen-carry-trade-explained-pros-cons-how-it-is-today-3305971
16. “More Pain Seen for Worst FX Strategy as Carry Traders Suffer,” Bloomberg; https://www.bloomberg.com/news/articles/2018-03-28/more-pain-beckons-for-worst-fx-strategy-as-carry-traders-suffer
17. “Japanese central bank’s policy inaction increases the allure of dollar-yen carry trade,” Bloomberg; https://www.bloomberg.com/news/articles/2018-08-14/dollar-yen-carry-trade-just-got-more-appealing-thanks-to-boj
19. “Briefing: The Return of Carry,” IPE; https://www.ipe.com/investment/briefing-investment/briefing-the-return-of-carry/www.ipe.com/investment/briefing-investment/briefing-the-return-of-carry/10022500.fullarticle