In our 2024 Global Outlook we warned about the risk posed by an unwinding of the yen carry trade (borrowing at zero or very low interest rates in Japan and investing the proceeds in assets with higher expected returns) that shook global markets last week:
"Decades of current account surpluses have accumulated, giving Japan the world's largest net international investment position (even more than China) with $3.3 trillion of investments held abroad according to the International Monetary Fund (IMF). Although the U.S. has the largest economic influence in the world, Japan may have the largest influence in the asset markets due to these account surpluses. Should the BOJ begin to substantially tighten monetary policy next year, as signaled by the end of yield curve control at the BOJ's meeting in October, the potential for a reversal of decades of outward flow of capital may be felt by investors worldwide."
– 2024 Global Outlook: The Big Picture published December 4, 2023
The yen rose 14% against the dollar in less than a month (July 10 to August 5) causing assets to decline in value against yen-denominated borrowing used to fund those purchases, forcing some investors to unwind their trades. The dramatic moves in markets globally on August 5 indicates this likelihood of forced selling, similar to a broad-based margin call. A combination of things likely fueled the recent move in the yen. On July 31, the Bank of Japan (BOJ) surprised with a bigger than expected rate hike and committed to further rate hikes along with faster than expected quantitative tightening (reducing the assets on their balance sheet purchased during a more than decade-long period of quantitative easing). Additionally, worsening U.S. economic data and some disappointing updates from some mega cap tech companies weighed on the dollar and stocks generally.
Going long on tech and short on the yen have been two very popular trades in recent years. It has been possible to borrow at the cheapest interest rate in yen, meaning the yen has been the cheapest major funding currency. Since tech has tended to be consistently profitable, it's not hard to imagine a good portion of the short yen trade flow has gone into U.S. tech. The chart below of the similar movement in the dollar-yen exchange rate and the tech-heavy Nasdaq highlights the likelihood of carry trades funding investments in tech, but the trade likely funded buying in other markets as well.
Is the unwind of the carry trade now over? While it is impossible to say exactly how big the carry trade is, there are some indicators we can look at to see how far the unwind could still go on a short-, medium-, and long-term basis.
Short-term unwind
To look at the size of a potential for a short-term reversal, we can examine yen contracts tracked by the Commodity Futures Trading Commission. On July 2, speculative investors, like hedge funds, were holding a net 190,000 contracts betting on a weaker yen (worth about $15.6 billion). By July 31, the day of the BoJ meeting, those positions were halved and were nearly back to the flat line by Tuesday, August 6th. While positioning could further unwind and perhaps even turn long, we feel that most of the extreme short position is unwound.
Medium-term unwind
A proxy for the medium-term carry trade magnitude is to look at Japanese banks' foreign lending in yen. This type of lending is often to non-banks, like asset managers, and has been on the rise since 2010. Foreign lending in yen accelerated in the last couple of years as rates rose outside Japan, while Japanese rates remained very low. According to the data released by the Bank of International Settlements (BIS), the loans totaled $1 trillion (145 trillion yen) as of March 2024. Unlike investors in futures that are subject to margin calls that can force urgent selling, asset managers may look to reduce any carry trades and pay back yen loans over the medium-term, dependent upon their outlook for currency and rate moves. This means an unwind of this exposure could unfold over the coming months.
Long-term unwind
For the longer-term carry trade size, we look to Japan's long-term net investment position. Japanese investors are the biggest non-U.S. investors in U.S. Treasuries and among the top five in ownership of non-Japanese stocks. According to the International Monetary Fund, decades of current account surpluses have accumulated, giving Japan the world's largest net international investment position (even more than China) with $3.3 trillion of investments held abroad as of March 31, 2024. The BOJ's current hawkish bias offers the potential for a reversal of more than a decade of outward flow of capital to be felt by investors worldwide. It is unlikely all the outbound investment from Japan will reverse given the scope of investment opportunities outside of Japan (and the investment policy of Japan's government-run pension fund which allocates 50% of the $1.6 trillion fund to foreign stocks and bonds). Yet, it may not be a one-way flow anymore with some capital repatriated to Japan over the coming quarters.
What else could end the unwind?
It has been suggested through various media outlets that perhaps the Federal Reserve will step in with an emergency rate cut prior to their scheduled September rate decision. Although softer economic and employment data may prompt the Fed to join other central banks in cutting interest rates, such a move is unlikely to halt the unwinding. An emergency cut by the Fed would tend to strengthen the yen against the dollar exacerbating the carry trade unwind, and not alleviate it.
Intervention by Japanese officials to limit the rise in the yen is another possibly. However, prior government interventions to limit currency moves have tended to be largely ineffective towards changing the yen's trajectory, only slowing the trend. The BOJ Deputy Governor suggested further moves in interest rates would take financial market volatility into consideration, which may have slowed the unwind in the near term.
A return to strong tech stock leadership could reinvigorate the carry trade. But, there are plenty of issues weighing on the sector which are likely to maintain volatility: underwhelming earnings outlooks from leaders like Alphabet and Tesla, the halving of Warren Buffett's stake in Apple, recent economic data—including the U.S. labor report—missing expectations, heightened global election uncertainty, and geopolitical conflict.
Safe haven?
The global stock market sell-off of August 5 saw a turnaround the next day with when markets rebounded. The bad news? The stock market recovery doesn't guarantee the risk has been eliminated. We believe that the most dramatic moves tied to the unwinding of the short-term yen trade may have passed but we will continue to track the data. For over a decade money was cheaply borrowed in yen and may have been invested in risky assets like U.S. tech stocks. Ultimately, we have no way of knowing how long or how far the drag on stocks and currencies from the 2024 carry trade unwind could go over the medium- or longer-term.
In our opinion, stock markets less exposed to tech, the dollar, and the yen, along with those that have stable economic backdrops and below-average valuations, seem the most likely to be better able to withstand any further unwinding of the yen carry trade. Europe's stock market fared much better than those of the U.S. or Japan on Monday August 5th, possibly for those reasons. The market's panicky moves offer a reminder about how portfolio diversification and a review of risk-exposures is prudent.
Michelle Gibley, CFA,® Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.
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