Japan’s Nikkei slumps 12% on Yen woes- The A, B, C of Yen carry trade and why is it spooking global markets?

Its mayhem across global markets today. The key Indian Indices – Nifty and Sensex are down around 3% each intra-day. But that’s relatively less than the bloodbath across Asia. The benchmark Japanese Index Nikkei nosedived over 12% while Korean markets plunged 10%. Even the US Futures indicate a negative start of trade in US markets.

What triggered the stock market crash?

Apart from the negative economic data emerging from US and geopolitical concerns in West Asia, the Yen trade unwinding in Japan is another key trigger. According to many, with Japan starting to hike interest rates, it could well mean an end for the Yen carry trade. The Yen incidentally is also rallying further adding to concerns.

Anup Kurup, CIO (Chief Investment Officer), InCred Global Asset Management believes that the Positioning in the derivative markets with many players selling volatility across many asset classes. A big move up in VIX on Friday after the disappointment in the jobs report would have likely triggered margin calls on the short vol strategies which were mushrooming off late. There are also other reasons including-

-Rumours of a hedge fund blow up in Japan this morning

-Yen, which many used as a cheap funding source, has been appreciating strongly in the past few days and moving 7% in the last 3 days and down 12% from the top.”

He added that “At InCred Global Wealth we have been short Japan in our Flagship Fund since Jan 2024 and have just gone tactically long post today’s move.”

Here is a quick look at what is Yen carry trade and why it’s spooking investors-

What’s the Yen Carry trade?

Essentially ‘carry trade’ is an investment or trading strategy. Typically investors borrow money from a country that’s offering lower interest rates and then the money is invested in a money with a relatively higher rate of interest. As a result of the currency rate difference and difference in interest rates, the rate of return is significantly higher.

This was particularly popular in Japan as for 30 years the Bank of Japan kept rates at zero and as a result this trade flourished and is estimated to be $4 trillion. Investors would borrow in yen and reinvest in dollar to earn higher return.

However, the Japanese Central Bank or the Bank of Japan has changed its approach to interest rates in the interest of the economy. The rates are at the highest level in Japan since 2008 and rates are now raised to approximately 0.25%. This is significantly higher compared to the 0- 0.1% range earlier.

In the past few weeks the Yen has seen a sharp 10% recovery and is now trading closer to 146 per dollar. This, many fear, will impact the profitability of key exporters in Japan.

Riya Oswal Bafna, Co-Fund Manager at Purnartha PMS said that “This panic has set off in global traders who have been borrowing in Yen for a long time at 0% and investing across the global for an arbitrage, with this increase in rate, they lose their arbitrage and this has resulted in panic across the global traders, thus resulting into selling at any prices.The recent rally and the strength in Yen
further eroded the earnings of Japanese companies who are mainly exporters thereby forcing the foreign investors there to sell Japanese stocks.”

Aniruddha Naha, CIO – Alternatives, PGIM India AMC pointed out that the “global risks associated with the interest cost rise in Japan and an appreciating Yen has led to the unwinding of the carry trade. This will have implications for global equities and is likely to see a rub off for Indian equities as well. Investors need to tone down return expectations and allocate towards equities over the next 9-12 months, hopefully reaping benefits over the next 3 to 5 years.”

How will this impact Indian markets?

The question then is though the relative fall in Indian markets is less than global peers, does Indian valuations have the strength to weather this storm?

Riya Oswal Bafna explained that, “US dollar denominated debt remained the largest component in India’s external debt with a share of 53.8% at March end, followed by debt denominated in Indian rupee (31.5%), yen was at 5.8% followed by the rest. RBI released a statement placing India’s external debt at $663.8 billion at the end of March 2024, a $39.7 billion increase since March 2023. Notably the RBI statement said that excluding the valuation effect, the external debt would have increased by $48.4 billion instead of $39.7 billion. The valuation effect is the difference between assets held abroad and domestic assets held by foreigners. According to RBI, the valuation effect due to the appreciation of dollar against major global currencies amounted to the $8.7 billion difference. The Yen has depreciated significantly in recent years, leading to a rise in Yen-denominated foreign loans. Thus, the effect is notable on India’s external borrowing.”