For decades, Japan’s ultra-loose monetary policies have made the yen carry trade one of the most influential financial strategies in the world’s financial markets. Investors were borrowing yen at near zero interest rates, investing the funds in higher yielding investments throughout the world and profiting from the interest rate differential.

As the economic environment for Japan changes, however, the unwinding of the yen carry trade increasingly puts the global markets at risk, threatening to cause wider economic and financial volatility, particularly for global liquidity, equity markets and emerging market debt.

What is the Yen Carry Trade?

The yen carry trade is a financial strategy where investors:

1. Take out money (in low interest yen) from financial institutions in Japan.
2. Convert the borrowed yen into other assets or investments that yield better returns (e.g. U.S. Treasury bonds, global equities, or emerging market debt).
3. Invest the money in these assets, gaining a return based on the differential in the interest rate between the low-interest yen and the target assets paying a higher rate of interest.

Japan’s ultra-low interest rates and quantitative easing policies made the ideal environment for the strategy to thrive. For much of the early 2000s Japan had near-zero interest rates and the Bank of Japan’s (BoJ) quantitative easing led to even lower borrowing costs. This resulted in a steady flow of capital from Japan to world markets in search of better returns. For example, if investors had borrowed yen at zero rates of interest and invested in U.S. Treasury bonds, which offered a yield of 2-3%, they made profits from the interest rate differential. The outcome was the massive flow of capital worldwide into investments with higher yields, especially in the developed and emerging markets. As a result, the yen carry trade becameone of the most important contributors to capital flows around the globe. According to estimates from the Bank for International Settlement (BIS), the carry trade was worth hundreds of billions of dollars in annual transactions affecting major global asset classes, such as U.S. equities, global bonds, and emerging market assets.

The Importance of Japan’s Monetary Policy

Japan’s protracted ultra-loose monetary policy was the cornerstone of the yen carry trade. The country has had a very low inflation levels and stagnant economic growth since the early 1990s. To counteract these difficulties the Bank of Japan (BoJ) took a series of extraordinary measures:

1. Zero Interest Rate Policy (ZIRP): The BoJ set the interest rates near 0%, which effectively made yen the cheapest currency in the world to borrow from.
2. Quantitative Easing (QE): To stimulate lending and borrowing, the BoJ expanded the size of its balance sheet by acquiring government bonds and other assets, which injects liquidity into the economy.
3. Yield Curve Control (YCC): In 2016, BoJ started the YCC (yield curve control) to target the yield curve. This policy was aimed at ensuring long-term interest rates remained close to 0% (making loans for Japanese financial institutions more appealing).

As a result, Japan became a world-wide source of cheap capital. The yen carry trade became deeply embedded in global financial strategies, with investors taking advantage of Japan’s lax monetary policies in an attempt to seek out higher returns from other financial markets. By 2015, the carry trade had become so large that it affected global liquidity, asset prices and volatility.

Japan’s Recent Monetary Shifts

However, in recent years, Japan’s economic environment has started to shift indicating the potential end to the era that supported the yen carry trade. A change in monetary policy in Japan started to take shape due to the increase of inflation and the recovering economic situation.

1. Rising Inflation: After years of deflationary pressures, Japan’s inflation rate has been steadily rising with inflation exceeding 2% for the first time in more than a decade in 2022. This increase in inflation, which is partly caused by rising commodity prices as well as wage increases, is another sign of the country’s economic recovery.
2. Wage Growth: In 2023, Japan saw a 3.5% growth in wages, the largest wage growth in some 20 years. As the wages increase, the inflationary pressures stress up, and this has left scope for a move in the monetary policy.
3. The End of Negative Interest Rates: The most significant development comes in 2024, in which the Bank of Japan began signaling the end of the negative interest rates policy. As a part of its normalization of the monetary policy strategy, the BoJ started raising interest rates and began to head toward an end of the aggressive quantitative easing. The ratcheting back from ultra-low interest rates in effect increases the cost of funding yen, which makes the yen carry trade less appealing.

This is a fundamental change in the monetary policies of Japan, which has had quite serious consequences for financial markets worldwide, particularly the ones based on yen-funded investments.

The Impact of the Unwind

As the yen carry trade winds down, a number of things will happen that could cause volatility in all forms of global financial markets:

1. Repaying Yen Loans at Higher Costs: The investors who borrowed yen at very low interest rates will now be faced with higher borrowing costs as Japan’s monetary policy tightens. This would potentially force them to sell foreign assets (such as U.S. equities, global bonds and emerging market assets) to generate money in yen to pay off the loans.
2. Currency Appreciation: The demand for yen will increase as investors convert back their foreign assets into yen. This will result in the strengthening of yen. Historically, the yen has had an appreciation spike during carry trade unwinds, with cataclysmic outcomes for global currency markets.
3. Capital Flight from Emerging Markets: One of the most immediate effects of the unwinding carry trade will be capital flight from emerging markets. Since a large number of emerging market economies have been heavily dependent on foreign inflows to fund domestic growth, the sudden outflow of capital could result in currency depreciation and inflation and also economic instability in these countries.
4. Sell-Off in Global Equities and Bonds: Unwinding of the yen carry trade would lead to a global sell-off in riskier assets In 2008 a similar unwinding of such carry trades resulted in massive asset liquidation and greater market volatility. A rebalancing of portfolios by investors trying to cover their positions could make the plunge in global equities even worse, particularly in tech stocks and other high-risk assets that have benefited from the flow of cheap capital into them.
5. Widening Credit Spreads: As investors reduce their risk by selling out of riskier assets like stocks, or as investors businesses sell out of them, credit spreads on high interest rate corporate and emerging market debt could widen. This would make it costlier for borrowers in these areas to access capital, thus further crimping growth potential.

The unwinding of the carry trade contributed to massive declines in global stock markets and emerging market currencies.

Structural Risks and Market Implications

The yen carry trade has introduced immense systemic risks which could multiply the financial impact of the unwinding of this trade:

1. Leverage and Systemic Risk: The carry trade has been a source of leverage for many of the world’s investors. The sheer size of the trade, which reached hundreds of billions of dollars. It has meant that its unwinding could lead to cascading deleveraging across markets, further exacerbating financial stress.
2. Emerging Market Vulnerabilities: Emerging markets have been especially dependent on the inflow of foreign capital to support growth. The unwinding of the yen carry trade could result in the sharp capital outflows, which could result in the depreciation of local currencies and increase the pressure for inflation. This could destabilize economies that are already very fragile, causing potential financial crises in regions such as Latin America, Asia and Africa.
3. Concentration Risk: The yen carry trade led to concentration of markets, especially equities in the U.S. and global bonds. As investors ease up their positions the global stock market could experience severe declines, particularly in tech stocks and other risky assets that have benefited from the inflow of cheap capital.

Market Perspective: How Investors Should React

As Japan tightens its monetary policy, market participants will have to be prepared for the possibility of volatility in the markets:

1. Diversification: Growing portsfolios away from asset classes heavily influenced by the carry trade is a good suggestion for investors, especially tech stocks and emerging market bonds.
2. Hedging Strategies: Given the possibility of currency volatility, exchange rate risk, investors may want to hedge their exposure to the yen through the use of currency options and forward contracts through managed foreign exchange risk.
3. Credit Risk Monitoring: Unwinding of the yen carry trade could result in credit spreads widening particularly in emerging markets. Investors must pay great attention to the credit risk within these regions and adjust exposures accordingly.

The unwinding of the yen carry trade is bound to become a major force of market volatility. As Japan starts to normalize its monetary policy and raises the cost of borrowing, global investors will be forced to unload their holdings, causing currency fluctuations, asset sales, and capital flows from emerging markets. The historical precedents of the 2008 financial crisis and the 2015 flash crash call attention to the potential systemic risks to the financial stability posed by the end of Japan’s ultra-loose monetary policy.

In the coming months, as the policy normalization in Japan unfolds, markets could lose a period of heightened volatility – one in which the hidden risks of the yen carry trade will be brought to fruition.