The yen carry trade and the importance of sound risk management
THE wild volatility in global markets caused by the unwinding of the yen carry trade may have subsided for now, but the aftershock may well be felt by investors for some time to come. The dramatic episode can serve as a timely reminder of the importance of sound risk management when making investment decisions – and the dangers of speculative leverage.
For years, the popular yen carry trade saw investors capitalise on a weak Japanese currency by borrowing money in yen at a low interest cost to invest in other currencies and assets offering greater yields – often riskier assets such as US tech stocks – to make a profit. Investors ploughed money into the trade following years of yen weakness and negative interest rates in Japan, and among many there was a strong expectation these conditions would continue.
The rationale was simple: If these investments performed well, yen interest costs stayed low, and the yen stayed the same (or weakened), returns were enhanced. However, there was always a significant risk that a sudden change in market sentiment, and a strengthened Japanese currency, could result in huge losses.
This latter scenario played out quickly. News of a surprise Bank of Japan rate increase arrived in late July just as the US Federal Reserve signalled plans for a rate cut. This narrowed the interest rate gap between the US dollar and yen, and marked a profound shift in currency markets.
The monetary policy shift in the US and Japan marked the end of the yen carry trade in spectacular fashion, wiping billions off the global stock market and resulting in one of the sharpest corrections since the Covid-19 pandemic. On Aug 5, the Nikkei experienced its worst day since Black Monday of 1987, while investors across the globe nursed significant losses as the aftereffects rippled from Hong Kong to London and New York.
The precise scale of the yen carry trade is unclear. Researchers at investment bank UBS estimate that more than US$500 billion in US dollar-yen carry trades have taken place since 2011. Meanwhile, analysts highlight US$350 billion in short-term external loans made by Japanese banks as a potential estimate of yen-funded trades.
At the higher end of the scale, there are estimates that the total size of the trade could have surpassed the US$1 trillion mark at its peak.
In early August, analysts estimated the yen carry trade was only 50 per cent unwound, with more than US$200 billion unwinding between late July and Aug 7. As recently as last week, market strategists warned the unwinding may have further room to run. There may still be significant risks present for global investors caught on the wrong side.
A lesson for investors
The sudden unwinding of the trade and resulting global stock market rout has been a sobering lesson for investors. Despite the confidence of investors in July, short-term speculation, the use of speculative leverage, including in carry-trade currencies, will always be a high-risk bet.
As evidenced in this case, such strategies can unravel quickly in times of high market volatility. Overnight, the advantages of low interest cost yen and the relative strength of other markets can be overturned in a risk-off environment. Following the Bank of Japan’s rate hike, increased yen interest rates implied higher funding costs, while the assets used to make investments also fell – a disastrous combination that resulted in margin calls and forced liquidations at unfavourable times.
Many investors are unaware of the risks of speculative leverage or the possibility of steep losses from such investment strategies. During the 2008 Global Financial Crisis (GFC), I met people who lost everything due to yen carry trade strategies, even facing negative equity in some of them.
The lesson learned during the GFC is the same today – trying to be too clever and taking on undue risks for a small extra return is often not the most responsible strategy.
While some traders are fully cognisant of the risk-reward equation, the yen carry trade most likely was not appropriate for the overwhelming majority of investors.
Risk assessment is key
What can we learn from August’s market turbulence? That transparency of risk and assessment of suitability, including risk/volatility tolerance, timeframe, and investment objectives, are essential. Investment decisions need to be tailored to individual needs, just like medical treatment. Not every financial product or investment strategy suits every investor.
Weeks on from the unwinding of the yen carry trade, there are signs that traders are returning to the strategy amid a stabilisation in global markets. Investors should heed the lessons of the recent past and evaluate risks and suitability. Time and time again, history tells us that using speculative leverage and betting with high conviction on any one specific scenario can quickly backfire.
The writer is head of Asia and Middle East investment advisory, St James’s Place
