[Why&Next] Will the 'N Carry Trade' Liquidation Continue?

Yen Carry Trade Liquidation to Continue Steadily
Trend of Narrowing 'US-Japan Interest Rate Gap' That Weakened Yen
If US and Japan Move as Expected, Liquidation Scale Will Increase

One of the causes of the recent sharp decline in global stock markets is attributed to the 'yen carry trade liquidation,' and there are forecasts that the yen carry trade liquidation may continue gradually in the future. This is because the interest rate differential between the US and Japan, which has so far encouraged the expansion of yen carry trade funds, is showing signs of narrowing due to successive interest rate decisions by the US and Japan, leading to an expected long-term decrease in the returns on these funds.

[Image source=Reuters Yonhap News]

On the 31st of last month, the Bank of Japan (BOJ) raised its policy rate from 0?0.1% to 0.25%, narrowing the US-Japan interest rate differential. Additionally, with expectations that the US will implement a 'big cut' (a 0.5 percentage point cut in the benchmark interest rate) along with a rate cut in September, analyses suggest that yen carry trade liquidation will continue. However, recent assessments indicate that the market impact of the yen carry trade liquidation has been somewhat exaggerated. The so-called 'Black Monday' was caused not only by the liquidation of these funds but also by the spread of US recession concerns, worries about the overvaluation of global artificial intelligence (AI) companies, and the announcements of policy rate decisions by major countries occurring simultaneously.

On the 6th and 7th in the Tokyo foreign exchange market, the yen-dollar exchange rate traded around 145?146 yen. Compared to the intraday low of the 141 yen range on the 5th, the yen's strength has somewhat eased. At the beginning of last month, the yen-dollar exchange rate surpassed 161.72 yen intraday, marking the highest level (yen weakness) in 37 years and 6 months since December 1986. However, after the BOJ's surprise rate hike on the 31st and leaving room for further rate increases, coupled with the US Federal Reserve (Fed) hinting at a possible rate cut in September, the yen-dollar exchange rate fell to the 141 yen range. This represents the yen's strongest level in about seven months since January.

Recently, the sharp appreciation of the yen has led to the liquidation of yen carry trade funds. The yen carry trade refers to borrowing low-interest yen to invest in higher-yielding overseas assets such as those in the US. In the past, when global interest rates were rapidly lowered, Japan alone maintained negative interest rates, leading to a trend of investing using ultra-low interest rates. However, with the recent BOJ rate hike and the possibility of a US rate cut and 'big cut' in September, investors concerned about the narrowing interest rate differential are liquidating their funds.

However, regarding the sharp decline in global stock markets on the 5th, the influence of yen carry trade liquidation is considered somewhat exaggerated. Kyuho Choi, a researcher at Hanwha Investment & Securities, said, "In the past, yen carry trade liquidation volumes have steadily appeared but were not significant enough to greatly impact the market. Major countries' rate decisions usually occur with a lag of one or two months, but recently, with consecutive rate announcements from Japan, the UK, and the US, the impact of yen carry trade liquidation has been somewhat excessive."

Sanghyun Park, a researcher at Hi Investment & Securities, said, "The recent global stock market decline was caused by a combination of factors: heightened US recession concerns, profitability controversies surrounding AI companies that had driven the stock market, and Middle East tensions coinciding. The possibility of a stock market crash solely due to yen carry trade fund movements is low."

Kyeongwon Min, a researcher at Woori Bank, said, "The recent global stock market plunge is seen as a panic sell. It started with US recession concerns and was compounded by the yen carry trade liquidation flow, leading to the sharp decline."

He added, "Yen carry trade liquidation has been mentioned since the BOJ rate hike in March, but there was no significant liquidation movement. While yen carry trade itself had some influence, psychological factors reacting to recession concerns were also reflected in the stock market plunge."

US Rate Cut and Additional BOJ Hike: If as Expected... Liquidation Flow Will Expand

There are forecasts that the scale of yen carry trade liquidation could increase further. If the BOJ takes interventionist actions before the Fed's rate decision in September, the liquidation scale may shrink, but if the US proceeds with a rate cut as expected in September and implements a big cut, and the BOJ also raises rates further, the liquidation flow could expand significantly.

Researcher Min said, "If the Fed cuts rates in September, the yen could strengthen, necessitating BOJ's policy response, so it is necessary to closely watch BOJ's policy moves in the short term before September. If the BOJ softens the atmosphere regarding additional rate hikes or shows interventionist moves, a recurrence of yen carry trade liquidation is unlikely."

He continued, "If the US cuts rates by 50 basis points (1bp = 0.01%) in September, the scale of liquidation could increase further. Considering only yen carry trade liquidation, a one-time market shock could occur."

Researcher Choi said, "I do not expect the volume of yen carry trade liquidation to increase significantly in the future. However, since the US-Japan interest rate differential will vary depending on whether the US cuts rates by 25bp or 50bp in September, the magnitude of the Fed's rate cut will be a key variable."

Some still believe that yen carry trade will continue. Researcher Park said, "If the US cuts rates and the dollar weakens, the yen is unlikely to weaken further, which could reduce the attractiveness of yen carry trade. However, since Japanese interest rates remain relatively low, there is still room for some investors to borrow yen and invest."