How a popular trade collapsed — and why it matters

Episode Summary

Executive Summary: The episode explains how the yen carry trade works, why it became crowded, and why it rapidly unwound in August 2024. Falling US rates, a BOJ hike, rising yen, and crowded positioning triggered a volatility spike that forced deleveraging across portfolios. The guests argue the carry trade remains a durable market feature, but re-entry will depend on calmer yen volatility and the US growth outlook.

Main Topics: What a yen carry trade is (Priority: 5/5): A carry trade borrows in a low-yielding currency and invests in a higher-yielding one, profiting from both the rate spread and favorable FX moves. In this episode, yen funding is the main example. How crowded the trade became (Priority: 5/5): Both speculative and institutional investors built large yen-funded positions through 2023 and early 2024, encouraged by Japan’s near-zero rates and attractive yields abroad. Why the trade unwound (Priority: 5/5): The spread narrowed as the Bank of Japan raised rates and US data weakened, increasing expectations for Fed cuts. Yen appreciation then hit crowded positions and accelerated liquidation. Risk management and market contagion (Priority: 4/5): Losses in yen-funded positions triggered VaR shocks and forced broader risk reduction, spreading volatility into equities and other trades beyond FX. Institutional Japanese capital and hedging behavior (Priority: 4/5): Japanese pensions and other institutions have continued buying foreign assets with relatively low hedge ratios, making the unwind stickier and harder to measure than speculative flow. Is the carry trade over? (Priority: 5/5): The speakers stress that carry trades are a permanent market feature, but this specific yen version may stay under pressure until volatility falls and macro conditions stabilize.

Key Arguments: Carry trades work by borrowing in a low-rate currency and investing in a higher-rate currency, earning the interest-rate spread and potentially FX gains. The yen was an unusually effective funding currency because Japanese rates were pinned near zero while US and EM yields were much higher. The trade became heavily crowded in 2023-2024, especially among hedge funds, CTAs, and Japanese institutions seeking returns abroad. The unwind was driven by both a narrowing rate differential and rising yen, as the BOJ hiked and US economic data weakened. Crowded positioning made the move self-reinforcing: yen strength caused losses, losses triggered VaR-driven de-risking, and de-risking pushed more assets lower. Broader market volatility was not caused solely by the yen carry trade; disappointing earnings, AI-related concerns, and frothy equity positioning also mattered. Institutional Japanese flows are slower-moving and may continue to unwind or hedge more, especially if yen strength persists. Carry strategies will likely reappear, but not until realized and implied volatility in dollar-yen normalize and the US growth outlook becomes clearer.

Data Points: Japan-US rate gap: Nearly 5 percentage points - Illustrative spread between borrowing in yen and investing in US assets after the pandemic inflation surge Japan-Mexico carry spread: Nearly 9-10% - Example of a higher-yielding emerging-market carry trade funded in yen Second wave of yen carry trades: Since 2016 - Period when Japan adopted negative interest rates, making yen even more attractive as a funding currency Positioning: Record yen shorts in July 2024 - Positioning metrics showed extreme speculative short yen exposure before the unwind Positioning change: Largest monthly change since records began - Magnitude of the liquidation during the early-August reversal Speculative flow: Pretty much paired all the way back down to flat - Hedge fund and CTA yen short positioning after the unwind Historical hedging ratio: About 60% - Historically, around 60% of Japanese foreign investments were currency hedged Current hedging ratio: Around 45% - Multi-year low hedge ratio for Japanese institutional foreign investments Japanese foreign bond holdings: About $2 trillion - Estimated total foreign bond holdings held by Japanese institutional investors Japanese equity holdings susceptible to FX move: About $1 trillion - Additional equity holdings potentially exposed to yen movements Japanese stock move: More than 10% decline - Japanese stocks were among the biggest movers during the volatility episode BOJ hike: 15 basis points - Recent Bank of Japan rate increase, still leaving rates near zero in rounding terms US rates: About 5% - US interest rates remained materially higher than Japan’s Mexico rates: About 10% - Example of continued high-yield destination that could still support carry trades Podcast recording date: Monday, August 12, 2024 - Date the episode was recorded

Pivotal Quotes: "a carry trade is a strategy or an investment strategy where an investor borrows in a currency where interest rates are low and invests in a currency where interest rates... are higher" — Kamakshia Trivedi: Definition of carry trades and why they generate returns "we actually saw the largest change in monthly positioning since we started taking records" — Praneet Shah: Description of the speed and scale of the yen position unwind "it doesn't take very much to move things the other way" — Kamakshia Trivedi: Explaining why crowded positioning can produce outsized volatility

Implications: The unwind shows how crowded, FX-funded trades can amplify volatility across markets. Carry trades are not disappearing, but re-entry likely waits for lower yen vol and clearer US growth signals.