Yen Carry Trade at a Crossroads: How Interest Rate Hikes in Japan Are Shaking the Markets

One of the main triggers for the recent market turbulence was the unwinding of the Yen Carry Trade by international investors. We analyze what this investment strategy entailed and why a relatively moderate interest rate hike by the Bank of Japan could cause such turmoil.

The Yen Carry Trade has been a well-known and widely used investment strategy for many years, based on exploiting interest rate differentials between the Japanese yen and other currencies. Due to traditionally low interest rates in Japan, it was an attractive way for many investors to achieve higher returns. However, in recent years and especially lately, the conditions have changed, making the future of this strategy uncertain.

Negative Rates Pay Off

Since the 1990s, Japan has pursued a low interest rate policy to stimulate its domestic economy. This led to interest rates in Japan remaining extremely low for decades. In 2008, the Bank of Japan cut the key interest rate to 0.1%, and even to -0.1% in 2016. These negative rates made the yen particularly attractive for carry trades. Investors could borrow in yen at almost no cost and invest in higher-yielding assets in other countries, such as the USA, Australia, or emerging markets, to achieve significantly higher returns compared to the financing costs of yen loans. Depending on the risk appetite, investments were made in government bonds, fixed deposits, stocks, or real estate.

But this strategy is not without risks, as many Austrian homeowners who financed their property with a yen loan are aware. A key risk factor, in addition to potential interest rate changes, is exchange rate risk. Should the yen appreciate against other currencies, the currency gains initially achieved through the interest rate differential could quickly be nullified.

Small but Mighty

After years of extremely low and negative interest rates, the Bank of Japan initiated a reversal in 2024. On July 31, 2024, the key interest rate was raised to 0.25%, after being increased from -0.1% to 0.1% at the end of February 2024. This interest rate hike, although still moderate compared to other countries, represents a significant change in Japanese monetary policy.

Given that major central banks like the ECB and the Fed have now made their first rate cuts or are about to, and the Bank of Japan has only cautiously begun an interest rate hike phase, the future of this strategy is questionable. This development reduces the attractiveness of the Yen Carry Trade, as the interest rate differentials that once formed the core of this strategy are increasingly eroding. A decline in interest rates in the USA and Europe could significantly diminish the returns sought by investors through the carry trade, while further appreciation of the yen would exacerbate the exchange rate risk. In such an environment, investors are forced to reassess their positions or search for alternative investment strategies.

Yen Appreciation Threatens Profitable Carry Trade

Concern has grown that the long-standing practice of the Yen Carry Trade might soon cease to function. In fact, the yen has risen by around 10% against the euro since mid-July, indicating that investors are already responding to the new conditions and partially closing their yen loans, for which they need to buy yen. The turbulence in the financial markets on Monday, August 5, 2024, can partly be attributed to these developments. The rapid appreciation of the yen and the associated uncertainty have led to a sell-off in high-risk assets, particularly in markets heavily dependent on foreign investment.

Interest rate arbitrage or foreign currency financing deals, no matter what they are called, will continue to play a significant role in the global financial world, as they still offer lucrative opportunities for investors. However, the Japanese Yen Carry Trade has held a special position, being a staple in the investment strategies of many investors for decades.

The recent market turbulence, triggered by the appreciation of the yen and the ensuing uncertainties, has been surprisingly well absorbed. The Bank of Japan acted swiftly and signaled that no further interest rate hikes are planned in the near future. It is clear that Japan’s decades-long ultra-low interest rate policy cannot be adjusted without challenges. Nevertheless, we are confident that investors and markets will now have sufficient time to adapt to the new conditions. As a result, the recent market movements in Japan are likely to be the exception rather than the rule, and we expect the situation in the equity markets to stabilize.

This information represents a market overview and the market opinion of Kathrein. It does not constitute financial analysis and includes no direct or indirect recommendation for the purchase or sale of securities or an investment strategy. When investing in securities, price fluctuations and thus capital losses are always possible. The purchase of securities on credit represents an increased risk. The loan must be repaid regardless of the success of the investment. Additionally, credit costs reduce returns. Statements and representations of performance with reference to the past do not allow reliable conclusions about future results.