When two popular trades, such as buying US big tech stocks and selling the Japanese yen, are unraveling at the same time, investors naturally think they are somehow related.
There is now worry that the unwinding of yen-funded carry trades would wreck investors’ frothy exposures to US technology and artificial intelligence-related companies. After all, the 11 percent surge in the Japanese currency since early last month has been in lockstep with the NASDAQ 100 index’s 13 percent maximum drawdown.
With a carry trade, an investor borrows in the currency of a country with low interest rates, such as Japan and China, and puts their money in one where they can get considerably higher returns. In recent years, the yen has been the most popular funding currency, because of the Bank of Japan’s (BOJ) zero-rate regime.
This strategy turned sour, really quickly, when the BOJ hiked rates last week.
The question now is the size of this carry trade. Some investors might have borrowed in yen, and exchanged the amount into US dollars to purchase popular tech stocks such as Nvidia Corp and Microsoft Corp. This year, the Japanese currency is more correlated with the Philadelphia Stock Exchange Semiconductor Index than the country’s own TOPIX.
It is also possible that asset managers had piled into hard-to-sell assets, such as emerging markets bonds, and brokers’ margin calls forced them to offload the most liquid positions in their portfolios. US big tech stocks would be good candidates in this case.
As a result, if this carry trade runs into trillions of dollars, its disorderly unwinding would necessarily magnify the downward move in US stocks. The NASDAQ sell-off might get a reprieve for a day or two, but it would not be entirely over.
Unfortunately, it is impossible to pin down the exact size of this strategy, because unlike stock trades, currency transactions are not tracked centrally on exchanges. The best we have are estimates.
The Wall Street Journal made an insightful observation. One proxy to look at is Japanese banks’ foreign lending. The amount reached US$1 trillion as of March, a 21 percent rise from 2021, Bank of International Settlements data show. The article said that much of the recent growth in cross-border yen lending has been in the so-called interbank market, where banks lend to each other and to other financial firms, such as asset managers. It is an estimate of how much appetite foreign institutional investors have for yen-funded carry trades.
How about Japanese investors? Their net international investment amounted to ￥487 trillion (US$3.3 trillion) as of the first quarter, a 17 percent increase from three years ago. Clearly, much of this comes from foreign reserves. Traditional asset managers’ portfolio carry trades would not be the biggest chunk.
However, in a broader sense, one could argue that the entire Japanese government is engaged in a massive carry trade. It has been funding itself at very low real rates imposed by the BOJ on domestic depositors, while earning higher returns on foreign assets. As such, the US$1.8 trillion Government Pension Investment Fund, which has allocated roughly half of its money to overseas equities and bonds, is essentially the asset manager that runs this money-making machine for the government.
Would the investment fund still be in the US stock market if the BOJ continues to raise rates?
Ultimately, a carry trade is a leveraged play, with people using cheap loans on riskier projects. The BOJ changed its game plan. Now, we are looking at strong repatriation flows back into a currency that is suddenly paying interest to the tune of trillions of dollars. What happens in Tokyo matters greatly to New York.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. She is a CFA charterholder.
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