![A major complication for the global market](https://news7g.com/wp-content/uploads/2024/08/108016156-1722861143183-gettyimages-2164867716-AFP_36A92LR-780x470.jpeg)
The Nikkei 225 rallied on Tuesday, rising 10.2%, after falling 12% on Monday. That drop, the worst for Japan’s stock market since 1987, was about more than just the slowdown in the U.S. economy and whether global stocks should lower their multiples. That could be worth a 2% to 4% drop. Those losses were largely about the yen carry trade. In its simplest form, the yen carry trade allows investors to borrow cheap yen to invest in higher-yielding assets, usually currencies. When there is a big difference in interest rates, say 4% in the U.S. versus near zero in Japan, the trade can seem like free money. But it can go bad very quickly if rates start to move. A bigger problem is how opaque the whole business is. How big is the yen carry trade? For example, since there is no central source for tracking currency trades, we don’t know how big the yen carry trade is. But it is big. The Wall Street Journal notes that Japanese banks’ overseas lending hit $1 trillion in March, up 21% from 2021. We don’t know where all that money goes. The common explanation is that some of it is invested in currencies, some in stocks. But we don’t know. We also don’t know who is using the carry trade. The typical answer is institutional investors or hedge funds. That’s certainly true, but we don’t have a detailed breakdown. Finally, we don’t know how much leverage is being used. There are a lot of unknowns, but I’d bet that the Federal Reserve and the Bank of Japan were a little shocked by the 12% drop in the Nikkei. How the Yen Carry Trade Works The core issue is that the Japanese central bank has been talking about higher interest rates. The yen is appreciating, and that makes the yen carry trade less profitable. Here’s a simple example. “XYZ Hedge Fund” borrows 10 million yen, which until recently cost just a little more than zero interest. The fund takes the proceeds and buys US dollars at 155 yen to the dollar, roughly where it traded in July. The fund now has $64,516, where you could earn a yield of over 4%. That sounds like nothing. Things could go wrong, because the fund still borrowed 10 million yen and has to pay it back. If the value of the Japanese yen starts to rise, the fund has to pay back that debt with more dollars. Remember the $64,516? If the yen rises from 155 to 145, the trading price on Monday, it will cost $68,965 to repay that 10 million yen ($10 million divided by 145 = $68,965). Suddenly, XYZ Hedge Fund has to spend $4,449 of its own money to repay the loan ($68,965 – $64,516 = $4,449). And that’s just a small matter. Some funds can have hundreds of millions of dollars in this trade. Leverage makes this even more complicated. Much of this is done on margin, where the hedge fund borrows money from a brokerage firm. If the value of the investment declines and the equity falls below the minimum level set by the margin agreement, the brokerage firm can issue a margin call requiring the hedge fund to deposit more money or sell securities. Depositing more money means finding more yen or starting to sell. With the Nikkei down 12% on Monday, a lot of people have sold. The bottom line The price of financial assets is not determined solely by valuation metrics like earnings and multiples. Flows—the amount of money flowing into an asset class—are also a key determinant. The yen carry trade has generated huge cross-market flows, which are likely to be a significant driver of flows into the US dollar and global equities, including US equities. It is certainly not unreasonable to believe that a significant unwinding of this trade, if it continues, will be an additional drag on US equities. No wonder the ever-sharp Nicholas Colas at DataTrek notes that, “Until the yen stabilizes, it is hard to see global equity market volatility abating.” One positive sign: The ETF to watch is the Invesco Japanese Yen ETF (FXY), which tracks the price of the Japanese yen, which had six times its normal volume yesterday. After soaring for five straight days, it fell 0.6% on Tuesday on much lower volume.