What is the carry trade everyone is talking about, that potentially triggered today's market crash?
Japan's Nikkei droped over 25% since early July's highs.
Japan's stock market has seen significant declines, with the Nikkei falling today by more than 10%, South Korea's market dropping about 8%, and other global markets also seeing major losses.
Japan has had very low or negative interest rates since the 1990s to fight deflation and stimulate economic growth by encouraging spending and investment. This environment was advantageous for institutions involved in the "carry trade," where investors could profit from both currency devaluation and rising asset prices.
In the carry trade, investors used "arbitrage," buying yen at low rates, converting them to US dollars, and investing in US stocks and bonds. This allowed them to finance their investments at very low costs. For instance, before 2020, while the US Federal Reserve's interest rates were above 2.5%,
Japan's rates remained at -0.1%, creating a 2.4% spread.
Investors borrowed yen and invested in US assets, benefiting as the yen weakened and asset values rose.
After the pandemic, Japan faced inflation due to supply chain issues and higher commodity prices, pushing the Nikkei to a 30-year high. However, when the US Fed began raising rates in 2022, the yen depreciated sharply, from around 103 in March 2023 to 160 by June 2024.
To stabilize the yen, the Bank of Japan raised its key short-term interest rate from 0-0.1% to around 0.25% in July 2024, leading to a 10% yen appreciation in July.
This rate hike ended the carry trade, as higher borrowing costs in yen led investors to close their positions, causing a major sell-off in both Japanese and US markets.
This outflow of money from the US, where Japanese investors are significant holders and lenders, has pressured Wall Street. About $4 trillion is at risk, and further yen appreciation could trigger more market unwinding.
A stronger yen also hurts Japan's stock market, heavily reliant on export-driven companies, creating a ripple effect.
