The Japanese Yen carry trade: Why did it contribute to a global stock market decline and what investors should do?

The unwinding of the yen carry trade contributed to the drop in global markets on Monday. It had to do with recent policy actions by Japan's central bank, which prompted foreign investors to liquidate their assets. Here's why. On Monday (August 5), major stock markets around the world had their steepest plunge in decades. While there were plenty of reasons to be concerned about investor attitude, such as the US economy's increased chances of a recession or rising geopolitical tensions as a result of West Asian turbulence, there was a new global trigger: the unwinding of the yen carry trade.

What is Japanese Yen Carry Trade?

Global investors are constantly looking for methods to make money. One method is to borrow money in a country with low interest rates and then invest it (after changing the currency) in a country with substantially higher interest rates. Simply defined, this is a carry trade.

Such possibilities can arise because central banks in many nations strive to keep interest rates at a level that is appropriate for their own economic conditions. A example in point is Japan, where the central bank (the Bank of Japan) kept interest rates at zero percent between 2011 and 2016, and has actually lowered them even lower (-0.10%) since 2016. The goal behind low interest rates is to boost economic activity.

However, such a "cheap money" monetary strategy has worldwide implications, particularly given that Japan is the world's third-largest economy and its currency, the yen, is widely trusted. For example, low interest rates encourage investors to borrow cheaply in yen and invest in other nations (such as Brazil, Mexico, India, and even the United States) in the hope of earning higher profits. Such carry trades are known as yen carry trades.

Because the BoJ kept interest rates so low for so long — even when central banks around the world quickly raised interest rates in the aftermath of the Russia-Ukraine war — it incentivized billions of dollars of "yen" carry trades, and these borrowings fueled investments in a number of countries.

Between mid-March and the end of July this year, the BoJ hiked interest rates by 35 basis points, bringing the rate to 0.25% from -0.1% earlier. On the surface, this may not appear to be a significant rise, particularly in India, where loan rates can reach 6.5%, but in Japan, it was nothing short of a monetary earthquake. Worse, the Bank of Japan is poised to boost interest rates even further.

This sudden reversal—a 25 basis point hike announced on July 31st—caused what is known as the "unwinding" of the yen carry trade. In other words, it caused investors who borrowed in yen and invested in Brazilian real, Mexican peso, or Indian rupee to sell their assets on foreign markets.

Why is the Japanese Yen trade unwinding?

Higher interest rates in Japan caused the yen to strengthen versus the dollar and most other emerging country currencies. Over the last week, the yen's exchange rate has risen versus currencies such as the dollar, real, rupee, and peso.

In other words, assets held in these currencies were worth less when converted back into yen. Not to add the increased opportunity cost of yen carry trade, as investing in yen now yields higher profits. This narrowing of the returns (or yields) gap — and the possibility of more movement in this direction — initiated the drop, prompting investors to sell off assets purchased with cheap yen.

What should investors do?

Switch to High-Quality Stocks

The market is likely to shift from low-growth, low-quality areas to enterprises with strong fundamentals and long-term growth prospects. Suggest that investors prioritize high-quality stocks with a track record of consistent returns.

Orientation to Large Caps

Maintain a significant concentration on large-cap stocks, as they are more stable and resilient, particularly during periods of market volatility.

Selective exposure to midcaps and small caps.

While large caps should form the foundation of your portfolio, don't ignore quality chances in midcaps and small caps. In these segments, look for companies with great fundamentals, long-term growth potential, and decent management.

Monitor global events.

The worldwide market slump caused by the unwinding of the Yen Carry Trade, together with other variables such as US recession fears and Middle East hostilities, may continue to cause volatility.

Rebalancing portfolios.

Given the probable underperformance of certain sectors and the current global market volatility, now is a good moment for investors to examine and adjust their portfolios, focusing on quality and growth-oriented assets.

Adopt a Long-Term Perspective

Despite short-term volatility, a long-term investment strategy based on quality and growth is likely to produce superior rewards. Stay invested in fundamentally strong companies that are well-positioned to weather market volatility and deliver long-term growth. Keep an eye on global developments and modify portfolios accordingly to protect against further declines.