Yen Crisis Review: Do the Risks of the Carry Trade Signal the End of the Sell-offs?

After Tuesday's gains, investors are wondering: "Are the sales over?" and "When should I buy?" Wall Street believes the worst is over. However, to better understand the current developments, we need to look to Japan to analyze the so-called carry trade. The Japanese yen is closely correlated with U.S. tech stocks, which have driven the market this year. Currency fluctuations are largely based on interest rate differentials, flight to safety during crises, and international trade. Japan was stuck in a deflationary spiral for decades, which it is only now emerging from, and interest rates have hovered around the zero line for decades. As the last country with negative interest rates, Japan reached positive territory this year, raising rates to 0.1% in March and again to 0.25% last week. In contrast, U.S. interest rates have been over 5% for a year, and the European Central Bank has remained just below 4% after a cut in June. This large interest rate differential led to a group of investors who borrowed cheaply in Japan and then invested in higher-yielding assets elsewhere – the so-called carry trade. Ed Yardeni, President of Yardeni Research, explained the details on Yahoo Finance’s Morning Brief. Many speculators borrowed at zero interest rates in Japan, converted yen to dollars and other currencies, and invested the money in global assets. Thus, the yen weakened while the dollar strengthened. Since 2010, this persistent selling pressure on the yen, combined with the demand for the U.S. dollar, has made the dollar twice as valuable as the yen – a significant move for a developed currency. The yen's plunge even prompted the Bank of Japan to intervene occasionally, but extremely low interest rates encouraged capital outflows. Now that the BoJ is hiking rates, the trend is reversing, and international capital is flowing back into the yen. Leverage and volatility work like masochistic siblings, amplifying losses in times of crisis by wiping out positions in a short period. Moves that would normally take months occur within days. The markets survived the first round of margin calls on Monday and Tuesday, but bear markets do not emerge overnight. When looking for clues about future direction, investors should also consider developments in the U.S. markets. In the second half of July, investor portfolios experienced an uncomfortable rotation from megacaps to small caps and value sectors. Combined with recession fears due to softer U.S. economic data and a Fed chair ready to cut rates, many investors were quick to sell. Wall Street leans towards a quick resolution. Morgan Stanley's distribution division wrote to its clients: "We are closer to the end of the selling than to the beginning." According to Arindam Sandilya, Co-Head of FX Strategy at JPMorgan, we are 50% to 60% through the unwinding of the carry trade. Yardeni himself sees the end even closer: "The unwinding should be over by the end of the week.