As of 2024, Japan is the 4th biggest economy in the world, and facing a unique set of challenges. At the cusp of late-stage capitalism, it is the canary in the coal mine for western, debt-fuelled economies; with weak demographics, an aging population, falling birthrates, rampant inflation and inescapable government debt, it presents a unique blend of difficulties for its citizens who are feeling the economic squeeze. Although it is not isolated, the circumstances of the Japanese economy send ripples through the global markets as evidenced by the unwinding of the Yen Carry Trade in the early weeks of August 2024. This article serves as an explanation of the Japanese carry trade and its consequences.
Historically Japan has maintained some of the lowest global interest rates due to a variety of social and economic circumstances, and not by a small margin. As other countries raised interest rates over time to combat inflation, ranging from 2.5 -5.5%, Japan has maintained 0 or negative interest rates since the beginning of the 21st century. Skipping over the motives and repercussions of these decisions, the differential between the interest rates has presented a unique opportunity for a foreign exchange strategy, the Yen Carry Trade,
expanded on in the following steps:
Loan the Yen at diminutive Japanese interest rates.
Convert the loan into another more stable currency, e. g. USD.
Purchase high-interest investments/ assets in the new currency, a common and relatively safe example would be US Government Bonds.
Sell or otherwise retrieve the value from the investments, converting back to the initial currency, paying off the debt and keeping the profit.
This may seem all too simple and effective, and for the most part it is; however it is not risk-free with the devil in the details. The strategy works very well with analyst estimates of 1.1 to 4 trillion USD tied up in the trades in 2024, a significant fraction of the global market value. You may then ask, what’s the big deal? The strategy only functions if all four steps succeed. If the interest rates in Japan were to rise, the currency exchange rate between the Yen and USD were to change or the value of investments failed to go up, the carry trade would break down. And what was once a profitable venture for traders and managers would become an economic disaster, as investors scrounge to extract value before it is too late.
‘Central Banks Extend Interest Rate Plateau’, ‘Japan Ends Negative Rate Policy as Deflation Fears Subside’ – STATISTA
The carry trade began to unwind on July 31st 2024 when the Bank of Japan raised interest rates from negative (in order to stimulate economic growth) to 0.25%, the first increase in 17 years. At the same time the exchange rate between the Yen and USD was falling, due to an increasingly weaker yen, which has lost more than 20% of its value against the dollar since 2022. Japan in the meantime was selling its USD foreign currency reserves in a desperate move to prop up the yen’s value. During the same week at the beginning of August the markets dropped and the three pillars of the carry trade collapsed simultaneously.
The unwinding of the Yen Carry Trade led to a loss of hundreds of billions of dollars in assets, with estimates reaching into trillions. This resulted in a global selloff further damaging the markets and leading to a 12% drop in the Japanese stock market, a fall of 20% in the Tokyo Stock Price Index marking its biggest three-day wipeout in history and a decline of 3.3% for the S&P, its worst trading day in over two years. It was an international financial disaster indeed. This all begs the question: is there more to come?
2nd August 2024 Market Chart
The Japanese economy continues to gradually unwind as the government has used debt to incentivise growth following the real estate bubble of the 1980’s, from which it has never fully recovered. Its dwindling demographics and crushing debt have cornered the land of the rising sun into a never-before-seen economic dilemma. The country cannot raise interest rates as this would push national spending into paying off interest and leave a lack of funding for public and government needs, social services, infrastructure or the military as some examples. The economy continues to grow weaker, while the average person feels the squeeze of financial pressure.
Japan is worth watching. It serves as a cautionary tale, the canary in the coal mine for debt-locked economies, the US, Europe, and China. Unless these choose to implement measures, Japan may not be alone in its position for long. How the Japanese choose to tackle their economies' challenges will be a lesson on the global stage.
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