What the ‘Carry Trade’ Had to Do With Monday’s Stock Market Rout

U.S. stocks tumbled yesterday amid a global equities selloff led by Japanese stocks, which had their worst day since 1987. 

One key contributor to the rout: The unwinding of the yen carry trade.

What Is a Carry Trade?

A carry trade is an investment strategy that involves borrowing the currency of a territory where interest rates are low and investing it in a place where interest rates are high. 

The Japanese yen has been a favorite currency to borrow among carry traders in recent years due to historically low interest rates. Japan has struggled with deflation and sluggish growth for decades. As such, the Bank of Japan (BOJ) has held interest rates incredibly low far longer than any of its global peers. Japan only abandoned negative interest rates in March when other major central banks were pondering rate cuts.

The carry trade’s success is dependent on a few different factors. First, it relies on interest rates on the borrowed currency remaining low. And it relies on stable markets. And recent developments in the U.S. and Japan shook both carry trade buffers. 

The Bank of Japan Prompts Unwinding

The Bank of Japan last Wednesday surprised markets when it raised its policy rate by ten basis points to 0.25%, only its second rate hike in the last 17 years. The bank also outlined plans to slow bond purchases as it seeks to wind down economic stimulus. 

The takeaway for many was that Wall Street had underestimated the central bank’s hawkishness.

“Given the central bank’s apparent willingness to look through subdued activity data, and apparent desire to front load policy normalization, we now forecast faster BoJ rate hikes than previously,” wrote Wells Fargo economists in a note last week.

The policy change came amid a rapid rise in the yen’s value relative to the dollar, a trend that has accelerated in recent sessions. Since July 10, the day before a soft U.S. inflation report set Wall Street’s sights on interest rate cuts, the value of $1 has declined from ¥161.7 to ¥144.18, its lowest since early January. 

The BOJ decision also came hours before the Federal Reserve announced it was leaving its federal funds rate unchanged, and signaled that interest rate cuts could be on the table at its next meeting in September. 

U.S. Rate Cuts Threaten Carry Trade

The unwinding of the carry trade hastened last week when data on Friday showed the U.S. labor market weakened far more than expected in July. 

The data prompted some to wonder whether policymakers had put themselves behind the curve by foregoing a July rate cut, keeping the benchmark rate at a range of 5.25% to 5.50%. It also raised the prospect that the Fed could make a big 50 basis-point cut in September or even hold an emergency meeting to lower rates before then. 

Economic jitters weighed on U.S. stocks on Friday as speculation about aggressive policy easing sent the value of the dollar tumbling to its lowest since March. Simultaneously, volatility jumped to its highest level all year and, on Monday, continued to surge to its highest since March 2020’s Covid-19 selloff.

What’s Next?

Markets stabilized on Tuesday, with more than 80% of the stocks in the S&P 500 posting gains as of midday. Japan’s Nikkei surged more than 10%, its biggest jump since 2008. But analysts warn the carry trade could unravel further.

“The carry trade unwind, at least within the speculative investing community, is somewhere between 50%-60% complete,” Arindam Sandilya, co-head of global FX strategy at JPMorgan Chase, told Bloomberg TV on Tuesday.

The trajectory of the U.S. economy is likely to play a critical role in the future value of the yen and, subsequently, the future of the carry trade, according to Taro Kimura, senior Japan economist at Bloomberg.

“The yen’s moves from here probably depend mostly on how the U.S. economy evolves and how policymakers at the Federal Reserve react,” he said.

Further deterioration in the labor market or other evidence of an economic downturn could prompt the Fed to move aggressively, subsequently weakening the dollar and fueling the unwinding.

Correction—August 5, 2024: This article has been corrected to state the Bank of Japan broke with negative interest rates in March of this year.