Japan hikes into the world's most crowded trade

The Bank of Japan surprised markets on 31 July by raising its benchmark interest rate to 0.25 per cent and announcing plans to halve its monthly bond purchases. Governor Kazuo Ueda was tightening policy straight into the most crowded speculative position in global finance, the leveraged short-yen carry trade.

The move completes a turn that began in March, when the BoJ ended eight years of negative interest rates, scrapped its cap on long-term bond yields and stopped buying equity funds. That first step was so cautious that the yen kept falling, reaching a thirty-eight-year low of 161.9 per dollar at the start of July and drawing repeated intervention from the Ministry of Finance. Officials had signalled in June that a plan to reduce bond buying was coming. Few in the market expected a rate rise to arrive alongside it.

Everyone borrowed in yen

For months, macro funds and retail currency traders had borrowed yen at almost no cost and put the money into higher-yielding assets, from Latin American debt to US tech shares and government bonds. Leveraged net short positions in the yen were close to seventeen-year highs. By raising rates and signalling more to come, the BoJ pulled the rug from under a carry trade worth hundreds of billions of dollars.

The appeal was easy to see. With the Federal Reserve's policy rate at 5.25 to 5.5 per cent and Mexico's central bank holding its rate at 11 per cent, a trader could borrow yen for next to nothing and collect a wide spread, with the falling yen adding a currency gain on top. Japanese households joined in on a smaller scale, encouraged by an expanded tax-free investment scheme launched in January that steered savings into foreign equity funds.

The bond-buying plan matters as much as the rate rise. The BoJ owns roughly half of all Japanese government bonds, and halving its purchases over the next two years means private investors, including the domestic life insurers that have been buying foreign assets, will have to absorb more of the supply at home. Higher yields in Japan give those institutions a reason to bring money back, which would add a slower, steadier source of yen buying to the rush by leveraged funds.

How the unwind works

A carry trade makes steady small profits until the funding currency rises. At that point the maths turns brutal. A fund that borrowed yen to buy dollar assets now owes more, in dollar terms, than it did, and the loss on the currency can wipe out many months of interest income in a few days. Brokers demand more collateral. To meet those calls, the fund must sell the assets it bought and buy back yen, and that buying pushes the yen up further, forcing the next fund to do the same.

The positions are not confined to currency desks. Borrowed yen has financed holdings of American technology stocks, emerging-market bonds and a range of other assets. When a fund is forced to raise cash, it sells whatever is most liquid, not necessarily what it wants to sell, which is how a Japanese policy decision can move share prices in New York or bond yields in Mexico City.

Lessons from 1998 and 2007

There are precedents, and they are not comforting. In October 1998, weeks after the near-collapse of Long-Term Capital Management, the yen rose by more than 10 per cent against the dollar in about a week as leveraged funds scrambled to repay yen loans. In August 2007, as the first cracks in American subprime lending appeared, another carry-trade unwind sent the yen sharply higher and hit currencies such as the Australian and New Zealand dollars. In both cases the move in the funding currency was far larger than any change in interest rates could justify, because positioning, not fundamentals, set the pace.

The case for calm

There is a reasonable counter-argument. A rate of 0.25 per cent is still tiny, and the gap with American rates remains around five percentage points. On paper, the carry remains lucrative, and the BoJ has shown every sign of moving slowly. Governor Ueda has also stressed that financial conditions will stay accommodative. If the yen merely drifts higher, traders can trim positions gradually rather than all at once.

The weakness in that argument is that carry trades are not held on interest-rate spreads alone. They depend on low volatility, and the ratio of the income earned to the risk of a sharp currency move is what keeps leveraged money in place. Japan's own intervention this summer, followed by a rate rise that many did not expect, has already pushed volatility up. Once that ratio worsens, risk managers force positions down whether or not the spread is still attractive.

What to watch

The Federal Reserve's meeting ends the same day, and markets expect it to open the door to a September cut, which would narrow the gap from the other side. American jobs figures at the end of the week will test that expectation. Weekly positioning data from the Commodity Futures Trading Commission will show how quickly speculators are cutting their yen shorts, and a move in the yen through 150 per dollar would suggest the unwind has gathered pace.

The BoJ has taken aim at the carry trade, and the unwinding is likely to be fast and disorderly. Funds that borrowed in yen will probably have to sell what they bought with it, and the selling could spread well beyond Japan in the coming weeks. Expect the most crowded positions, from the Mexican peso to the biggest technology shares, to take the first hit, and expect leveraged macro funds rather than Japanese savers to absorb most of the losses.