What is the “Yen Carry Trade” and Why Did It Blow Up Markets?

When we invest, it’s a given that there’s going to be volatility of some kind. On the way down, that means sharp drops in stock prices (scary, I know)! 

But that’s part of the whole process of trying to grow our wealth for the long term. There will be intermittent moments of sheer terror based on that “sea of red” when we take a look at our portfolio.

One such occasion actually took place in the first week of August and, as investors, it’s important we understand why such big market sell-offs occur. It helps us stay “zen” when the market is freaking out.

 

Many people were pointing to Japan as the cause of the latest violent declines given what’s called the “Yen carry trade”. Indeed, the Nikkei Index—a key stock market index in Japan—saw its worst decline (in percentage terms) since 1987, tumbling 12% in just 1 day. Needless to say, that’s not normal.

These declines were a global phenomenon because the world’s largest stock market—the US—also fell sharply while the local stock market here in Singapore saw similar falls.

So, you are probably scratching your head and asking the very understandable questions “Wtf is the Yen carry trade?” and, additionally, “why should I care”? Well here are the answers to both those questions.

 

The Japanese Yen carry trade

Obviously, the Yen carry trade refers to the Japanese currency—the Japanese Yen. The actual trade that’s involved with it is called a “carry trade”.

Now, it doesn’t really involve anyone having to carry a massive bag of Japanese Yen banknotes around with them. It’s more to do with simple maths and wanting to make money…like we all do!

In markets, there are many traders that operate on short-term horizons and place trades with timelines that can range anywhere from a few days to a few months. What they’re hoping for is that their trade is right, duh! If it is, they make money but if they’re wrong then they have to exit the trade (i.e. cut their losses).

Simply put, a “carry trade” involves borrowing money in a currency that has a super low interest rate, like Japan’s. For context, Japan’s interest rate—set by the Bank of Japan (BOJ)—was in the range of 0% to 0.1% in July 2024. That is super cheap money!

However, that’s just the first part. Secondly, they then need to invest that borrowed money into assets of a currency that have potentially higher returns or yields. Look at the US, where interest rates are above 5% and the stock market is on a sizzling hot streak—from the beginning of 2024 to the end of July the S&P 500 Index in the US had risen over 16%.

Alright, now we’ve covered the basics of the carry trade. The Yen carry trade saw a lot of traders borrow some seriously cheap money in Japan (in Yen), exchange them into US dollars and then invest those US dollars into assets that could give them a bigger return (like US stocks).

 

Why the Yen carry trade came crashing down

Of course, borrowing in 1 currency and investing in another doesn’t just come down to the interest rate. There’s also the foreign exchange (FX) rate to consider. 

Unless you’ve been living under a rock the past 2 years—and not travelling to Japan like every other Singaporean and their family!—then you would have realised that it’s been a brilliant time to go to the country on holiday. Why? Well, the Japanese Yen has been so weak against the Singapore dollar that it means your money goes a lot further when you’re there due to the favourable exchange rate.

Similarly, the Japanese Yen had weakened a lot against the US dollar so far in 2024—at least up until the start of July. In fact, from the end of 2023 to 30 June 2024, the Japanese Yen had weakened against the US dollar by just over 14%.

 

Show me the MONEY!

That is a huge percentage move in just 6 months for a currency pairing as large as the US dollar and Japanese Yen. So, for short-term traders throughout 2024, if you were borrowing in Japanese Yen, exchanging it into US dollars immediately, and then investing it, you were essentially escaping the weakening of the Yen just by virtue of holding US dollars! 

Even if you don’t invest those US dollars, you were already making bank (in Yen terms). Of course, it makes much more sense to put those US dollars into hot tech stocks like Nvidia, though. You can kind of see the positive correlation between the US dollar-Japanese Yen exchange rate and the Nasdaq-100 Index (a big tech-focused stock market index in the US). They have moved nearly in tandem, as you can see from the chart below.

Correlation between the USD/JPY and the Nasdaq 100

Source: Bloomberg

The Japanese Yen actually started to strengthen as we entered July. But something big changed in the last week of July that really accelerated the reversal of the trend of the US dollar strengthening/Japanese Yen weakening. Basically, the Bank of Japan surprised everybody by raising its interest rate to 0.25% at a meeting on 31 Jul 2024.

Then on the same day, the US Federal Reserve had its own policy meeting and, from the comments it made, it gave the market the idea that it was open to maybe cutting interest rates when it next met in September. Then, just 2 days later (on 2 Aug 2024), there was some data that were released in the US that related to its jobs market.

Unfortunately, this employment report wasn’t so great. It showed that the number of jobs the US economy created in July was 114,000. Yes, that sounds like a lot BUT the stock market was expecting 179,000 jobs to be created. So that was a big shortfall, hence the market started throwing a tantrum and stocks began to sink fast.

 

The Tay Tay craze and the Yen carry trade

Taken together, global market traders (and the stock market at large) were not vibin’ with this. Think of it almost like the mad rush we saw to buy tickets to see Tay Tay in Singapore when they were released early for those of us who had UOB credit cards.

Everyone—and I mean everyone—went to UOB’s site and tried to get those golden tickets. It was a mad rush for a big event that everyone wanted a piece of. Likewise, the Yen carry trade for most of 2024 was like that initial Tay Tay craze—every trader and their mother wanted a piece of the trade.

Remember this?

Source: UOB’s Facebook page

 

However, let’s think about a hypothetical. Imagine if UOB had then (for whatever reason) decided that those who had purchased tickets would now have to get a refund and you could only get a refund if you applied for one online within 12 hours.

What would the result be? Nearly certainly an absolutely mad rush for the doors (of refunds) and with the UOB site crashing. Well that’s exactly what happened to the market. All those who had been in the Yen carry trade had tried to exit at exactly the same time. The result? A massive market crash.

The size of the trade is a topic of hot debate. Many experts believe that it runs into the trillions—yep that’s trillions with a “t”—and that it’s only around 60-70% done. That could mean more volatility down the road.

 

What did it mean for Singapore’s stock market?

Well, like the rest of the world, Singapore’s own stock market also saw some pretty heavy falls on 5 Aug 2024—the same day that Japan’s stock market plummeted 12%.

Singapore’s Straits Times Index (STI) closed the day down 4.1% and was, at one point, down as much as 4.9%. 

The biggest stocks in Singapore, as we know, are the big banks; DBS, UOB, and OCBC. All 3 banks saw their share prices crater over 5%. Now, for banks—which are typically seen as stable and “boring”, that’s a massive move down.

Besides concerns around the Yen carry trade, the bank shares also declined because people expected the US Federal Reserve to start cutting interest rates as soon as September. Typically, when interest rates get cut in the world’s largest economy, it means banks everywhere make less money.

That’s because many loans are priced in US dollars and a whole range of lending activity is tied to the US interest rate. Given banks actually make the bulk of their profits from taking deposits (and paying us pretty crappy rates for them, let’s be honest) and then lending those same funds out at higher interest rates, it stands to reason that the prospect of lower interest rates would negatively impact investor sentiment for bank stocks.

On the whole, though, nothing much has changed with bank stocks in Singapore following the massive market decline in early August. If we look at the share prices of all 3 banks today, they’re pretty much back to similar levels they were at before the market fallout.

 

Understanding where we are today

In terms of the overall Yen carry trade, there are a number of opinions about how much impact it has left. Of course, right now global stock markets have moved on to the next point of focus—how strong the US economy is and how fast the US Federal Reserve will cut interest rates.

For Singapore investors, the episode has taught us that we are exposed to whatever happens in the global economy…even if it has nothing to do at all with our Little Red Dot!

It’s an important lesson that market declines can originate from anywhere but it’s also useful for us to be aware of why these declines happen in the first place. All of these episodes can help strengthen our resolve and make us more informed about any future market freakouts that come our way.

 

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