How ‘Carry Trades’ Contributed to Global Market Chaos

BANGKOK — The chaos that swept global markets this week was partly caused by a market strategy known as “carry trading.”

Japan’s benchmark Nikkei 225 index fell 12.4% on Monday and markets in Europe and North America suffered outsized losses as traders sold shares to help cover the increasing risks of investments made using low-cost financed funds borrowed mainly in Japanese yen.

Markets recovered most of their losses on Tuesday. But the damage persists.

They have been shaken by a combination of factors, including fears of a possible recession in the United States, the world’s largest economy, and concerns that technology stocks have soared too much this year.

But the scale of the declines was exaggerated by the rush to sell US dollars due to trade deals that helped drive markets to record levels.

What are carry trades?

Carry trades involve low-cost borrowing in one currency to obtain higher returns from investments in another currency. One of the most recent examples was borrowing the Japanese yen, hoping that the currency would remain cheap against the US dollar and that Japanese interest rates would remain low. The borrowed funds would then be invested in stocks and U.S. Treasury bonds in the expectation of a higher return.

Why are traders unwinding their carry trades?

The key factor behind a carry trade is the difference in interest rates. The Bank of Japan has kept interest rates at or near zero for years, trying to encourage more spending and spur economic growth. Last week, you increased your main interest rate of almost zero. Higher interest rates tend to increase the value of a country’s currency, and the Japanese yen has risen against the US dollar. Traders scrambled to sell riskier dollar-denominated assets to cover suddenly higher borrowing costs, as well as losses from changes in exchange rates and losses in asset values ​​as stock prices plummeted. Additionally, hedge funds that engage in carry trades use computer models to help maximize their returns versus their risks. They needed to sell shares to maintain acceptable risk profiles.

Why do carry trades have an outsized impact on markets?

Carry trades tend to make more sense when exchange rates are relatively stable and investors can take advantage of higher-yield market opportunities, such as recent stock price rises in places like the United States. Recent market disruptions have forced traders to cover their debts by purchasing yen and other carry trade currencies and selling relatively more of the riskier assets they purchased on more favorable terms. Additionally, carry trades are very profitable when stocks or other investments are rising, but losses can snowball when thousands of traders are pressured to sell stocks or other assets at once. “A huge reversal in the global carry trade was the spark that lit the fuse for this market Armageddon,” said Stephen Innes of SPI Asset Management. “A defining characteristic of these self-perpetuating market meltdowns is the vicious cycle in which a sell-off increases realized volatility.”

What is the future risk of carry trades?

The difference between Japan’s key interest rate, now at 0.25%, and the Federal Reserve’s benchmark rate of 5%-5.25% is still large, but is likely to narrow as the Fed lowers rates. rates and Japan increases its rates. Financial markets appeared to have calmed on Tuesday, with Japan’s Nikkei 225 index gaining 10.2% and other markets mostly rising. Analysts are divided on whether this period of market volatility has passed or if there is more to come. Regardless, carry trades have been used for decades. They contributed to a collapse in Iceland’s financial sector in 2007-2008, where investors took out loans in yen or Swiss francs to take advantage of high Icelandic interest rates. During this latest market disruption, Mexico, another focus of the yen carry trade, saw its peso fall more than 6%. The popular but potentially complicated trading strategy will likely remain a mystery to investors, especially in times of high market volatility.