The carry trade that blew up

The yen carry trade unwound in early August, and markets around the world lurched. War and corporate failure had nothing to do with it. The Bank of Japan raised rates while the Federal Reserve signalled that cuts were close, and the yen rallied hard, from 161.9 to roughly 142 per dollar. The rally set off a chain of forced selling.

The sequence took barely five weeks. The yen hit its low at the start of July, Tokyo intervened after soft American inflation figures in mid-July, the BoJ raised its policy rate to 0.25 per cent on 31 July, and a weak American jobs report on 2 August convinced traders that the Fed would have to cut quickly. Each step narrowed the expected gap between Japanese and American interest rates, and on Monday 5 August the pressure broke through: Japan's Nikkei 225 had its worst day since 1987 and Wall Street's volatility index briefly spiked to levels last seen during the pandemic.

Margin calls in yen

Hedge funds had borrowed cheap yen to fund leveraged positions in global tech shares, Mexican pesos and government bonds. As the yen rose, so did what they owed, and the margin calls followed. Fund managers had to dump whatever they could sell fastest, with little regard for price. The episode showed how a squeeze in an obscure funding currency can shake asset prices everywhere within days.

Why the yen became the world's piggy bank

For most of the past quarter of a century, Japan has kept interest rates at or near zero, and for eight years they were below it. That made the yen the cheapest currency in the world to borrow. The attraction grew as other central banks raised rates sharply from 2022 onwards, pushing the gap between Japanese and American short-term rates above five percentage points. A trader who borrowed yen and held dollars earned that spread each year, and the yen's steady fall added a currency gain on top.

The trade was not limited to hedge funds. Japanese life insurers and pension funds hold large portfolios of foreign bonds, some of them unhedged. Retail investors in Japan have poured savings into overseas equity funds. Foreign investors bought Japanese shares while shorting the yen to hedge the currency. Each of these positions benefits from a weak yen and suffers when it rises, so a sharp rally hurts a wide range of holders at once.

How the selling spread

Once the yen began to climb, the losses on short-yen positions forced funds to cut risk. The quickest way to raise cash was to sell liquid assets that had performed well, which in practice meant large American technology shares, the Mexican peso and other high-yielding currencies. Selling those assets and buying back yen pushed the yen higher still. Japanese stocks were hit twice, because a stronger yen reduces exporters' profits and because foreign investors who had bought Japanese equities cut their positions too.

The feedback loop broke only when the Bank of Japan stepped back. On 7 August its deputy governor, Shinichi Uchida, said the central bank would not raise rates while markets were unstable. Japanese shares recovered much of their loss, and the yen eased from its peak. The episode showed that the BoJ, whatever its long-term intentions, is sensitive to market turmoil at home.

Precedent and scale

Carry-trade unwinds have a history of arriving suddenly. In October 1998, 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. In 2008 the yen rallied again as the global financial crisis forced deleveraging. In each case the currency move was far larger than any change in interest rates, because it reflected the rush to close positions rather than a reassessment of value.

Nobody knows the full size of the trade, since much of it runs through derivatives and through institutions that do not report positions in a single place. Estimates vary widely. What is clear from weekly data on speculative futures positions is that leveraged funds had built very large yen shorts before the rate rise and cut them rapidly afterwards.

The case that it is over

The optimistic view holds that the worst has passed. Much of the speculative short position has already been closed, the BoJ has signalled caution, and markets have recovered a good part of their losses. The rate gap remains wide, so the carry trade still pays for those willing to take the risk. On this view, the August sell-off was a one-off clearing of excess leverage.

That reading is plausible for the fastest-moving money, but slower holders, such as Japanese insurers and households, adjust over months rather than days. If the Fed cuts more sharply than expected and the BoJ resumes raising rates, those investors may bring money home, adding sustained pressure on the yen.

What to watch

The key dates are the American inflation data this week, the Fed's Jackson Hole symposium in late August, and the Fed and BoJ meetings in September. A Fed cut of half a point or more, alongside any hint from the BoJ of another rise, would narrow the gap further and could set off another round of selling.

The unwind showed how much global leverage rests on cheap yen. If the BoJ keeps raising rates while the Fed cuts, more bouts of forced selling are likely, and they will hit the most crowded trades first. The next test comes with the September central bank meetings, and leveraged holders of Mexican pesos and big American technology shares will once again be the first to feel it.