The Unraveling of Carry Trading: How Rising Interest Rates and Yen Fluctuations Impacted Global Markets

In early August 2024, global markets saw a sharp downturn, with the S&P 500 plunging 325 points in just five days. Carry traders scrambling to offset their losses following an unexpected shift in Japan's monetary policy partly triggered the chaos. Carry trading, a longstanding strategy for investors, played a central role in this market disruption. This article unpacks how these trades work, the role Japan’s rate hike played, and how it amplified market disruptions.

Carry trading is an investment method in which traders borrow money in a low-interest-rate currency, such as the Japanese yen, and use it to purchase assets in nations with higher yields, such as U.S. bonds or stocks. Japan’s pro-growth monetary policies have led to exceptionally low and even negative interest rates for many years, making it a preferred funding source for international carry trades. The idea is straightforward: Traders can pocket the difference between low borrowing rates and greater profits by taking out cheap loans in Japan and investing in better-yielding assets abroad (Gratton, 2024).

However, this strategy is highly sensitive to changes in interest rates and exchange rates. Japan’s interest rates, which remained below 0.1% for 15 years (Feingold, 2024), provided the stability carry traders relied upon — until this summer. At the end of July 2024, the Bank of Japan (BOJ) announced a rate hike, pushing interest rates above 0.25% for the first time since the global financial crisis (Onishi, 2024). This unexpected move was a response to the yen’s weakening value in the global market, which had hit a tipping point in recent months. The yen’s appreciation mirrored past episodes, such as the 1998 Long-Term Capital Management (LTCM) hedge fund collapse and the 2007 subprime mortgage crisis, in which the yen appreciated 20% from its low (Adrian & Shin, 2010). The historical parallels highlight systemic risks when sudden shifts in interest rates and currency values occur— like Japan’s recent yen policy shift — which can destabilize interconnected financial markets. The LTCM crisis “demonstrated the interdependence of global financial markets,” in which currency appreciations forced position unwinding and amplified instability (Dungey et al., 2006). Similarly, the sudden liquidity tightening can “trigger asset fire sales and increase systemic vulnerability,” creating cascading risks across markets (Adrian & Shin, 2010). As of early August, the yen had already appreciated over 10% against the U.S. dollar (Holmes, 2024).

Japan's economy faced severe difficulties due to the yen's depreciation, such as eroding consumer purchasing power through rising import costs, especially with the remaining prevalence of global inflation pressure (Australian Government, 2022). The BOJ's interest rate increase was meant to counter this trend by stabilizing the yen and reducing inflation. For carry traders, meanwhile, this was an unfortunate development. Rising interest rates to 0.25% in Japan caused the cost of borrowing yen to soar. The yen's strengthening against the U.S. dollar as investors expected Japan to implement stricter monetary policy made matters worse for carry traders. Carry traders now faced two challenges: greater borrowing costs and lower returns on their U.S. investments because of the fluctuating currency prices.

This chain of events triggered a wave of brokers requiring traders to either deposit more collateral or sell off assets to cover potential losses as the value of their positions declined. “Once even minor losses began to accrue, lenders demanded that [borrowers] pony up more cash to cover [their] potential losses, a process known as a margin call” (Morrow, 2024). This cascade of margin calls forced carry traders to rapidly sell off assets, adding downward pressure on the S&P 500 and creating a feedback loop of volatility. With U.S. interest rates remaining relatively stable during the summer of 2024, the yen’s appreciation caught many off guard. In a frantic attempt to meet margin calls, traders liquidated large amounts of U.S. stocks, leading to the rapid decline in the S&P 500 and heightened volatility across the market (Morrow, 2024).

The collapse of carry trades highlights how intertwined the world's markets are and how changes in one nation's monetary policy can ripple across the globe. Japan's decision to raise interest rates was not limited to its home market — it sent shockwaves through international finance. The key takeaway for investors is that strategies, like carry trading, are highly sensitive to changes in interest rates and currency values. In a dynamic global economy, this episode serves as a reminder of the risks associated with assuming stability in such factors.

Edited by Jeffrey Wu

References

Adrian, T., & Shin, H. S. (2010). Liquidity and leverage. Journal of Financial Intermediation, 19(3), 418-437. https://doi.org/10.1016/j.jfi.2008.12.002

Australian Government. (n.d.). Japan-weaker yen and higher inflation hit consumers and businesses. Export Finance Australia. https://www.exportfinance.gov.au/resources/world-risk-developments/2022/august/japan-weaker-yen-and-higher-inflation-hit-consumers-and-businesses/ 

Dungey, M., Fry, R., González-Hermosillo, B., & Martin, V. L. (2006). Contagion in international bond markets during the Russian and LTCM crises. Journal of Financial Stability, 2(1), 1-27. https://doi.org/10.1016/j.jfs.2005.07.001

Feingold, S. (2024). Japan ends era of negative interest rates. A chief economist explains. World Economic Forum. https://www.weforum.org/stories/2024/03/japan-ends-negative-interest-rates-economy-monetary-policy/ 

Gratton, P. (2024). Carry trade: Definition, how it works, example, and risks. Investopedia. https://www.investopedia.com/carry-trade-definition-4682656#:~:text=The%20yen%20carry%20trade%2C%20a,as%20U.S.%20Treasury%20or%20stocks. 

Holmes, F. (2024). Understanding the yen carry trade impact on World Markets. USGI. https://www.usfunds.com/resource/understanding-the-yen-carry-trade-impact-on-world-markets/ 

Morrow, A. (2024). Analysis: A very popular trading strategy just blew up in investors’ faces | CNN business. CNN. https://www.cnn.com/2024/08/07/business/yen-carry-trade-stocks-nightcap/index.html 

Onishi, Z. (2024). Despite short-term volatility, rising interest rates may improve Japan’s economic outlook. Debt Explorer. https://debtexplorer.whitecase.com/leveraged-finance-commentary/despite-short-term-volatility-rising-interest-rates-may-improve-japans-economic-outlook#! 

Ota, K. (2024). An electronic stock board displays the rate of the yen against the US dollar outside a securities firm in Tokyo [Photograph]. Bloomberg. https://www.bloomberg.com/news/articles/2024-10-10/sell-yen-is-most-popular-trade-as-investors-brace-for-cpi-risk