[Initial Insight] A Closer Look at the 'N-Carry Trade'

Large-Scale Liquidity Confirmed in Yen-Borrowed Stock Investments
Shockwaves May Return if Unsettled Funds Are Released
Avoid 'Debt Investing'... Broaden Portfolio and Enhance Responsiveness

The "Carry Trade" began to emerge in earnest in the late 1990s. As Japan's policy interest rate approached zero, it became a major investment strategy for traders. At that time, the U.S. policy interest rate was maintained at around 5% for a long period. Borrowing money in Japan and investing in safe assets like U.S. dollar government bonds allowed investors to earn significant interest rate differentials. Carry trade is not primarily an investment strategy used in the stock market. Large global investment institutions mainly utilized it through bond and foreign exchange markets to gain interest rate arbitrage.

After the global financial crisis, during the period of quantitative easing (QE) when the U.S. lowered interest rates and injected massive liquidity, this strategy became ineffective. A trader at a securities firm estimated, "In recent years following the COVID-19 endemic, as the U.S. raised interest rates, yen carry trade funds likely surged again." Japan maintained zero interest rates until recently, and with the U.S. rapidly raising rates over the past 2-3 years, the carry trade arbitrage strategy has become effective once more.

There are several noteworthy points different from the past, experienced through market turmoil caused by the unwinding of yen carry trades. First is the stock market crash. Traditionally, since yen carry trade is a strategy pursuing interest rate differentials, its unwinding should lead to a decline in bond prices. However, during this unwinding process, bonds actually showed strength while the stock market took a heavy hit. This confirmed that yen carry investment funds flowed not only into bonds but also significantly into the stock market.

Second is the greatly increased market volatility. The decline in the stock market caused by the carry trade unwinding was reminiscent of the financial crisis. It is particularly important to note that the stock markets of Japan and South Korea, the epicenters of yen carry trades, experienced unusually large drops. The KOSPI and KOSDAQ fell by 13% and 15%, respectively, in just two days, triggered solely by Japan’s monetary policy pivot. This serves as a warning of how much shock yen carry trade unwinding can inflict on the domestic stock market.

What makes the market even more uneasy is the unpredictability of the ripple effects from the carry trade unwinding. How much yen carry trade capital exists? How much is invested in specific stock or bond markets? How much remaining volume is left to be unwound? All these remain uncertain. Economists and market experts have made various attempts to estimate the scale, but the conclusion so far is "unknown."

Shin Hyun-song, former Blue House International Economic Advisor and current Economic Advisor and Head of Research at the Bank for International Settlements (BIS) (also a Princeton University professor), recently posted on social media that while the on-book foreign currency-denominated yen credit amount was about 40 trillion yen (approximately 370 trillion KRW) as of the end of March, including loans using foreign currency swaps, yen carry trade funds could easily exceed 1 trillion dollars (about 1,360 trillion KRW). Some analyses even suggest the amount could reach several thousand trillion KRW.

If the U.S. begins to cut interest rates in earnest, the interest rate differential between the U.S. and Japan will narrow, likely strengthening the yen. In this case, the unwinding by carry trade investors who need to repay yen-denominated debt is expected to shock the market again. In this unpredictable situation, there are few strategies to respond. The best approach is to diversify portfolios, which are heavily concentrated in stocks, into bonds and other assets and prepare to respond swiftly to market changes. Averaging down on stocks with borrowed money during a market crash may be effective in hindsight but is not considered a good strategy.