The yen carry trade has been a well-known and widely used investment strategy for many years, based on exploiting interest rate differentials between the Japanese yen and other currencies. Due to the traditionally low interest rates in Japan, it has been an attractive way for many investors to achieve higher returns. However, in recent years, and especially recently, conditions have changed, making the future of this strategy uncertain.
Negative interest rates pay off
Japan has pursued a low interest rate policy since the 1990s to stimulate the domestic economy. This policy resulted in interest rates in Japan remaining at extremely low levels for decades. In 2008, the Bank of Japan cut the key interest rate to 0.1%, and in 2016 even to -0.1%. These negative interest rates made the yen particularly attractive for carry trades. Investors could borrow money in yen at almost zero cost and invest it in higher-interest investments in other countries, such as the USA, Australia or emerging markets, in order to achieve significantly higher returns compared to the financing costs of the yen loan. Depending on risk appetite, this was invested in government bonds, fixed-term deposits, stocks or real estate.
But this strategy is not without risks, as many Austrian homeowners who financed their property with a yen loan know. In addition to possible interest rate changes, a decisive risk factor is the exchange rate risk. If the yen were to gain value against other currencies, the currency gains originally achieved through the interest rate difference could quickly be wiped out.
Klein, well
After years of extremely low and negative interest rates, the Bank of Japan has initiated a turnaround in 2024. On July 31, 2024, the key interest rate was raised to 0.25%, after having already been raised from -0.1% to 0.1% at the end of February 2024. This rate hike, although still moderate compared to other countries, represents a significant change in Japanese monetary policy.
With major central banks such as the ECB and the Fed having now made or are about to make their first interest rate cuts and the Bank of Japan having only taken two cautious steps to begin a phase of rate hikes, the future of this strategy is in doubt. This development puts the attractiveness of the yen carry trade into perspective, as the interest rate differentials that once formed the core of this strategy are increasingly eroding. A decline in interest rates in the US and Europe could significantly reduce the returns investors want to achieve through the carry trade, while a further appreciation of the yen exacerbates exchange rate risk. In such an environment, investors are forced to reassess their positions or look for alternative investment strategies.
Yen appreciation threatens profitable carry trade
Concerns have been growing that the long-standing practice of yen carry trades may soon no longer work. In fact, the yen has risen by around 10% against the euro since mid-July, showing that investors are already reacting to the new conditions and partially closing their yen loans that they need to buy yen to cover. The turmoil in financial markets on Monday, August 5, 2024, can be partly attributed to these developments. The rapid appreciation of the yen and the uncertainty it creates have led to a sell-off in risky assets, especially in markets that are heavily dependent on foreign investment.
Interest rate differentials, interest rate arbitrage, foreign currency financing or whatever you call them will continue to play an important role in the global financial world as they continue to offer lucrative opportunities for investors. However, the Japanese yen carry trade has a special place as it has been an integral part of many investors’ investment strategies for decades.
The recent turbulence on the equity markets, triggered by the appreciation of the yen and the associated uncertainties, has been handled surprisingly well. The Bank of Japan reacted quickly and signaled that no further interest rate hikes are planned in the foreseeable future. It is obvious that Japan’s decades-long policy of ultra-low interest rates cannot be adjusted without challenges. Nevertheless, we are confident that investors and markets will now have sufficient time to adjust to the new conditions. The recent market movements in Japan are therefore likely to be the exception rather than the rule, and we expect the situation on the equity markets to stabilize.
By Harald Besser, Head of Portfolio Management at Kathrein Privatbank
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