Breaking Down the Consequences of the Japanese Carry Trade
In this podcast, I, Victor Menasce, shed light on an intriguing financial phenomenon that is the Japanese carry trade. This discussion is based on an insightful paper published recently by Brent Johnson and Michael Peregrin at Santiago Capital.
The carry trade is a financial strategy in which an investor borrows money at a low interest rate in one country, in this instance, Japan, and then invests that money at a higher interest rate in another country. The investor profits by capitalizing on the interest rate gap. Basically, they capture the yield differential between two countries.
The Dynamics of the Carry Trade
The carry trade activity tends to work smoothly provided the rate spread remains relatively stable and the currency exchange rate doesn’t fluctuate drastically.
Japanese banks have been leveraging the carry trade by borrowing massive amounts in yen at extremely low interest rates and then pouring those funds into higher yielding assets in other countries. The earnings stem from the interest differential, which is the actual ‘carry’ in this context. This strategy is beneficial as long as the exchange rate and the value of the acquired assets remain steady.
However, financial history reminds us that this scheme often ends disastriously, as witnessed in countries such as Australia, Switzerland, Thailand, Brazil, Mexico, Iceland, and indeed, Japan itself. Despite this, the lessons seem to be recurrently overlooked as history keeps repeating itself.
The Aftermath of an Overstretched Carry Trade
According to Johnson’s hypothesis, the yen carry trade has blown up, but not for everyone. Roughly $20 billion were impacted in August out of an estimated six to $700 billion still ensnared in such speculative bets. Some estimates put the size of the carry at over a trillion dollars. The vast nature of these transactions means unwinding them will take some time, adding further to the instability of the global financial markets.
Potential Impact on Global Markets
If the yen carry trade unravels, the ripple effects will be felt across international currency and equity markets. Expect to see the yen strengthen in the short term and increased volatility, along with redirection of capital from global markets back to Japan. This shift may potentially burden the US treasury market, as Japan is one of the largest holders of US bonds. Should Japan decide to sell US bonds at an accelerated rate, bond and capital markets worldwide could face significant downturn pressures.
The Japanese government is placed in a predicament where it can either protect the bond market or the currency, but not both at the same time. Raising interest rates to defend the currency heightens borrowing costs and destabilizes the bond market, whereas maintaining low interest rates to protect the bond market depreciates the currency, fuelling inflation.
Implications for Real Estate Investors
The carry trade fiasco may impact US real estate investors in an unexpected way. A sharp rise in US treasury yields, resulting from Japan’s mass selling of its US treasury holdings, will increase borrowing costs for real estate investors, irrespective of the Federal Reserve’s current strategy of lowering the Fed funds rate. Therefore, I recommend that investors lock-in their interest rates as soon as they settle on a rate they find acceptable.
The aftermath of the carry trade debacle serves as a reminder that global financial events can have unexpected ramifications for domestic investors. Therefore, it’s important to stay diligent, proactive and well-informed about global financial trends that can inadvertently affect local financial and investment climates.
