Carry unwinding in Japanese Yen: The current dynamics and global implications

Key points

• The yen-funded carry trades are seeing a sharp unwind as the market is expecting the Fed to signal a rate cut at its July meeting. Meanwhile, the Bank of Japan is expected to hike rates and tweak its bond purchases, which can support the yen.

• Such episodes of carry unwind have often occurred in the past, such as the removal of Swiss franc peg or the Turkish Lira crisis.

• These historical instances demonstrate how carry trade unwinding can tighten financial conditions and increase market volatility.

The carry trade, a popular strategy in the forex market, involves borrowing in a low-interest-rate currency to invest in higher-yielding assets. For years, the Japanese yen has been a cornerstone of this strategy due to Japan's persistently low interest rates. However, when market conditions shift, this strategy can unravel, leading to a "carry unwind," which has profound implications for the yen and global markets.

Understanding carry unwind

Carry trades can be highly profitable in stable market conditions, but they are vulnerable to shifts in risk sentiment or changes in interest rate differentials. When investors anticipate a downturn or escalating geopolitical risks, they become risk-averse and unwind these trades by selling higher-yielding assets and buying back the funding currency, in this case, the yen. This sudden demand for yen can lead to its sharp appreciation. As the yen appreciates, other traders may also decide to unwind their positions to avoid further losses, creating a feedback loop that accelerates the yen's rise.

Carry trades often involve high leverage. When the trades start to unwind, the need to cover positions can result in a rapid and large-scale buying of the yen, pushing its value up sharply. This is often called a Squeeze.

Historical instances

The 2008 financial crisis

During the 2008 financial crisis, the carry unwind played out dramatically. As global markets tumbled, investors fled risky assets and repatriated funds to safer currencies. The yen, benefiting from this flight to safety, appreciated significantly against other currencies. This rapid appreciation exacerbated global market turmoil, as the sudden strengthening of the yen hurt Japanese exporters and added to the financial stress worldwide.

Asian financial crisis (1997-1998)

Countries like Thailand, Malaysia, and Indonesia pegged their currencies to the US dollar, making their exports competitive and attracting carry traders. When the US dollar strengthened, these countries had to sell off their foreign currency reserves to maintain the peg. As conditions worsened, investors pulled out, betting against these currencies, leading to their collapse. The IMF intervened, providing loans in exchange for economic reforms, but the crisis left lasting impacts on these economies.

The Russian Ruble collapse (1998)

Russia’s status as a commodity superpower, and the high yields this can generate, has made the Rouble popular in carry trades, at least until the Ukraine invasion.

In 1998, the Russian ruble faced a severe crisis. Speculators betting against the ruble forced the Russian government to spend $6 billion of its reserves to maintain its peg to the US dollar. Coupled with plummeting commodity prices and poor tax revenue, Russia's debt exceeded 40% of its tax income. As investors fled, the ruble had to be devalued, leading to a massive financial crisis, soaring inflation, and social unrest.

The Swiss Franc peg removal (2015)

In January 2015, the Swiss National Bank unexpectedly removed the Swiss franc's peg to the euro, which had been in place since 2011 to prevent the franc from appreciating too much. The sudden move caused the franc to surge by almost 30% against the euro within minutes. This abrupt appreciation wreaked havoc on global markets, causing significant losses for investors and businesses that had borrowed in francs or held significant Swiss franc positions. The removal of the peg led to an unwinding of carry trades as investors rushed to cover their positions, resulting in severe volatility in currency markets.

The Turkish Lira crisis

In the early 2010s, the Turkish lira became a favorite for carry trades, especially among investors with US dollars. The US Federal Reserve had slashed interest rates to near zero, while Turkey's economy was booming, making the lira very appealing. However, political instability and economic mismanagement by the Turkish government, including heavy-handed tactics by Prime Minister Erdogan and interference in fiscal policies, led to a series of crises. In 2018, the lira depreciated significantly as investors lost confidence, resulting in a massive carry trade unwind. The Turkish central bank's attempts to control inflation by adjusting interest rates failed to stabilize the currency, leading to further economic turmoil and high inflation.

Current scenario

In the current market, signs of a carry unwind are emerging once again. Several factors contribute to this development:

Interest Rate Differentials: With central banks, particularly the Federal Reserve, signaling potential interest rate cuts, the attractiveness of carry trades diminishes. Investors are preparing for a shift in the interest rate environment, leading to a re-evaluation of their positions.

Global Economic Uncertainty: Rising geopolitical tensions, trade disputes, and slowing global growth are contributing to a more cautious market sentiment. Investors are increasingly seeking safe-haven assets, including the yen.

Japanese Economic Policies: Japan's economic policies, including those related to the yen, are crucial. Any indications of changes in Japan's interest rate policies or interventions in the forex market can influence carry trade dynamics.

Implications for global markets

The unwinding of carry trades involving the yen can have several significant impacts on global markets:

Currency volatility: A sudden appreciation of the yen can lead to increased volatility in the forex markets, affecting other major currencies and creating a ripple effect across global financial systems.

Global Liquidity: As investors bring money back to Japan, it effectively withdraws capital from other global markets. This reduction in capital flow can decrease global liquidity, making it harder and more expensive for companies and governments outside Japan to access funding. Lower liquidity can increase volatility and reduce the availability of credit in global markets.

Stock market pressure: Yen strength can hurt Japanese exporters by making their goods more expensive abroad, leading to potential declines in Japanese stock indices. This can also affect global markets, given Japan's role in the global economy.

Commodity prices: As the yen appreciates, commodities priced in dollars may become cheaper for Japanese buyers, potentially influencing global demand and prices for these commodities.

Investor sentiment: A carry unwind can signal broader market fears, leading to a more risk-averse environment. This shift can result in lower stock prices, increased demand for safe-haven assets, and higher volatility across asset classes.

In conclusion, the carry unwind in the Japanese yen is a critical event with far-reaching implications. Understanding its mechanics and historical context helps investors and policymakers navigate the potential turbulence in global markets. As signs of another unwind emerge, staying attuned to interest rate policies, geopolitical developments, and economic data will be crucial in anticipating and responding to market shifts.

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