The Nikkei 225 rose 10.2% on Tuesday after falling 12% on Monday. The decline was the worst for Japanese stocks since 1987 and was driven not only by a slowdown in the U.S. economy but also by whether price-to-earnings ratios for global stocks should be lower. That’s probably worth a 2%-4% drop. These losses were primarily related to yen carry trades. In its simplest form, the yen carry trade allows investors to borrow cheap yen to invest in a higher-yielding asset (usually a currency). When there is a huge difference in interest rates, such as 4% in the United States and almost zero in Japan, trade appears to be free money. But it could turn bad quickly if interest rates start to change. The bigger problem is how opaque the entire business is. How big is the yen carry trade? For example, we don’t know how big the yen carry trade is because there is no central source that tracks currency trades. But it’s big. The Wall Street Journal pointed out that Japanese banks’ external loans reached US$1 trillion in March, an increase of 21% from 2021. A common explanation is that some invest in currencies and some in stocks. But we don’t know. We also don’t know who is using arbitrage trading. The typical answer is institutional investors or hedge funds. That’s certainly true, but we’re not broken. Finally, we don’t know how much leverage was used. These are a lot of unknowns, but I bet the Fed and Bank of Japan are a little shocked that the Nikkei is down 12%. At the heart of the question of how the yen carry trade works is the fact that BOJ officials have been talking about higher interest rates. The yen is rising, making yen carry trades less profitable. This is a simple example. “XYZ Hedge Fund” borrowed 10 million yen, which until recently cost slightly more than zero interest. It used the proceeds to buy U.S. dollars at 155 yen per U.S. dollar, about where it was trading in July. With $64,516 in the fund now, you can earn over 4% interest. It sounds like having money is of no use. Things could go wrong because the fund still borrowed 10 million yen and must repay it. If the yen begins to appreciate, the fund will have to use more dollars to repay debt. Remember $64,516? If the yen rises from 155 to 145 (Monday’s trading price), it would take $68,965 to repay the 10 million yen (10 million yen divided by 145 = $68,965). Suddenly, XYZ Hedge Fund must spend $4,449 of its own funds to pay off the debt ($68,965 – $64,516 = $4,449). These are baby potatoes. Some funds may have hundreds of millions of dollars in the deal. Leverage makes things more complicated, much of which is done through margin, where the hedge fund borrows money from the broker. If the value of an investment declines and equity falls below the minimum limit specified in the margin agreement, the broker may issue a margin call requiring the hedge fund to deposit additional funds or sell securities. Depositing more money means finding more yen, or starting to sell. With the Nikkei down 12% on Monday, many are selling. Bottom Line The price of a financial asset is determined by more than just valuation metrics like earnings and price-to-earnings ratios. Flows – how much money flows into an asset class – is also an important determining factor. The yen carry trade creates huge cross-market flows. It could be an important driver of inflows into the U.S. dollar and global stock markets, including U.S. stocks. It is certainly not unreasonable to believe that this significant easing of trade, if continued, will bring additional headwinds to the U.S. stock market. No wonder the ever-savvy DataTrek’s Nicholas Colas noted that “until the yen stabilizes, it’s hard to see how global stock market volatility will decline.” One positive sign: An ETF to watch is the Invesco Yen ETF ( FXY), yesterday’s trading volume was six times normal levels. After five consecutive days of surges, trading volume fell sharply on Tuesday, falling 0.6%.
