What is the Yen Carry Trade And How Does It Impact the Markets?

A Look at the Markets - Vanguard All-World ETF

When there is high volatility in the markets news financial headlines often adopt alarmist tones using words such as ‘crash’, ‘recession’, crisis’, ‘tumble’, and ‘worst day since….’. Such language can create a perception of imminent financial disaster and potentially cause people to panic sell (selling something without reasonable thought - see ‘Word of the Day’ below). However, the reality is often less serious. Let’s look at an example below.

Vanguard All-World ETF

Despite the recent headlines, the Vanguard All-World ETF only dropped 10.6% from the recent highs (as of now - there could be a further drop in the coming days and weeks). At the time of writing (Thursday 8th August 2024) it is 6.1% below the recent high. This takes it to approximately the value at the beginning of June only 2 months ago!

It is important to maintain perspective and remember that short-term market movements do not necessarily indicate a change in the underlying fundamentals or long-term growth prospects.

My 5-Step Plan to Cope with Market Volatility

• Do not panic!

• Read the financial news for possible causes of the increased volatility or sell-off

• Decide if this indicates temporary volatility or a major fundamental change (such as war)

• Decide if I want to add to any positions. Dollar-cost averaging (when you buy assets at regular intervals no matter the price) works in your favour in this case.

• Be prepared for the market to fall further - nothing is certain!

Do not let emotion take over your financial decisions - happy investing!

What is the Yen Carry Trade and How Does it Impact the Markets?

I posted the following chart of USDJPY in this newsletter on the 26th of July 2024.

These are my comments at the time:

USDJPY did indeed drop to 142 and caused a lot of volatility and a major correction in the financial markets. Incredibly, much of the volatility seems to be due to a tiny increase in the interest rates in Japan from 0.1% to 0.25% on the 31st of July 2024. This may seem a small increase but it is a 150% increase and may signal a change in central bank policy. Hence, it had a big effect on the financial markets. Let’s look at an updated chart.

As previously discussed, this move caused around a 10% move in the equity markets and, we shall see later in this newsletter, over a 30% move in the cryptocurrency markets. But why?

The Yen Carry Trade

A ‘currency carry trade’ is when a trader borrows currency with a low interest rate and invests it in a currency with higher interest rates or even assets denominated in that currency. The trader hopes to gain the difference between the two interest rates or even more if they invest in higher-yielding assets in the new currency.

A common carry trade is buying the US Dollar against the Japanese Yen, which as we have seen, has very low interest rates.

What Can Go Wrong with a Carry Trade?

This technique sounds like ‘free money’ especially if the money is invested in safe assets such as US Bonds. However, the trade only works if the exchange rate stays the same as the new currency (in this case USD) or strengthens against the borrowing currency (in this case the Japanese Yen).

Here is an example:

• January 2023 - USDJPY 130 - Julia borrows 100,000 Yen from a Japanese bank and converts it to USD. She has 769.23$ to invest.

• July 2023 - USDJPY 140 - Julia wants to repay the loan (100,000 Yen plus a small amount of interest). She only needs 714.28$ (plus interest) to repay the loan.

Julia has gained because the exchange rate has moved in her favour plus the difference in the returns of the higher yielding USD investment compared to the low interest rate Yen.

Yen Carry Trade Unwind

Another example:

• June 2024 - USDJPY 160 - Jim borrows 100,000 Yen from a Japanese bank and converts it to USD. He has 625.00$ to invest.

• August 2024 - USDJPY 145 - Jim doesn’t want to repay the loan but he sees that he now would need 689.65$ to repay the loan (100,000 Yen plus a small amount of interest). This is more than he received in the original loan. The trade is rapidly becoming unprofitable.

• Worried that the exchange rate may move further against him Jim decides to repay the loan. To do this he must sell the assets that he was holding.

This is known as the Yen Carry Trading Unwinding as many traders copy Jim in repaying their Yen loans. Unwinding is when many traders try to close or reverse their positions at the same time.

Jim and Julia likely were both using leverage to magnify the gains but also the losses. This means that they used small deposits to borrow larger amounts of money - say 10:1.

You can now see how Japanese interest rates and the Yen carry trade unwinding, can have big effects on other financial markets.

The Bank of Japan has made an effort to calm the markets:

Is This Important for Retail Investors?

Is knowledge of the Yen Carry Trade important for retail investors like you and me? I think that it is. Not because I expect retail investors to use the carry trade and leverage.

However, I do think that it is important to have a basic understanding of the fundamentals of the financial markets so that we can make rational decisions and remove emotional reactions to price action.

Other Possible Reasons for Increased Volatility

It should be noted that there is often more than one possible reason for increased market volatility. Indeed, it is usually a combination of factors.

We discussed the Yen carry trade unwinding in the previous section. Other possible factors are:

• Economic Data: the US recorded an unexpected increase in the unemployment rate, raising fears of an economic slowdown

• Tech Sector Volatility: There have been mixed earnings reports from the Tech sector which makes up a very large weighting of the S&P 500.

• Geopolitical Tensions: Markets do not like uncertainty and the threat of war certainly brings that. There are tensions in the Middle East between Iran and Israel. In addition, the result of the Presidential Election is now more uncertain as Kamala Harris gains in the polls.

Generally, I feel that the US economy, which is the driver for world markets, is still reasonably strong. There may be fundamental changes in the future that we should watch out for - war in the Middle East, for example.

Cryptocurrencies and Market Volatility

Any increase in volatility in the equity markets is likely to be amplified in the cryptocurrency markets and this has been the case this week. Potential investors should be prepared for this before they invest in cryptocurrencies. We will look at the Bitcoin/USD chart below but the effect is likely to be further amplified with smaller cryptocurrencies by market capitalisation.

In a previous newsletter, we discussed the current rangebound price activity of Bitcoin since February 2024. Despite the headlines, Bitcoin only briefly dropped below this range and quickly rebounded back into the range. Bitcoin dropped 33.3% from recent highs and bounced back to a loss of ‘only’ 18.8%. I say ‘only’ because although this drop would be significant in other markets, it is normal in crypto markets - even in a bull market.

Of course, there could be a further correction, but at the moment the price action looks normal. Technical traders may even view the lows in early July and early August as a bullish (positive) sign. This type of chart pattern is called a ‘double-bottom’ (though it would have been better if the 2 lows had been closer in value). If the price drops from here there will be no double-bottom chart pattern. However, if the price were to recover to 72,000$, the double-bottom pattern would be completed with a potential for the price to go above 100,000$.

Do you think that Bitcoin will properly break out of this range to the top or the bottom? Time will tell.

Word of the Day - Panic & Panic Buying or Selling

Panic - noun - a sudden strong feeling of fear that prevents reasonable thought and action

Panic - verb - to suddenly feel so worried or frightened that you cannot think or behave calmy or reasonably

Panic buying - noun - a situation in which many people suddenly buy as much food, fuel etc as they can because they are worried about something bad that may happen (in the UK this happened at the start of the Covid-19 period)

Panic selling - noun - a situation in which many people suddenly start to sell company shares that they own because they are worried that their value is going to fall