Introduction
The global financial landscape has always been subject to the ebb and flow of capital, influenced by macroeconomic factors and monetary policies. One such phenomenon is the Yen carry trade, where investors borrow in Japanese Yen (JPY), a currency with traditionally low-interest rates, and invest in higher-yielding assets worldwide. This trade has historically had significant implications for global markets, particularly in periods of massive capital inflows and subsequent unwinds. The recent surge in Yen carry trades since January 2023 has raised concerns about the potential impact on global markets, especially as the Bank of Japan (BOJ) takes steps to manage the resultant volatility.
What is a Carry Trade?
To understand the recent movements in USD/JPY, it’s crucial first to grasp the concept of a carry trade. A carry trade is a popular investment strategy in the forex market where investors borrow money in a currency with a low-interest rate and invest it in a currency with a higher interest rate. The goal is to profit from the interest rate differential, also known as the “carry.”
For example, if the Japanese yen (JPY) has a low-interest rate, an investor might borrow yen and convert it into US dollars (USD) to invest in a US-based asset with a higher interest rate. As long as the exchange rate remains stable or moves in favor of the borrowed currency (JPY), the investor profits from both the interest rate differential and any favorable currency movement.
The Surge in Yen Flows: A Global Perspective
Since the beginning of 2023, there has been a significant increase in Yen-denominated flows into global equity markets. The Japanese Yen depreciated by 27% against the US Dollar (USD), dropping from 127 to 162 levels, which fueled this surge. Yen-denominated assets in global equity funds (excluding Japan) expanded from $200 billion in January 2023 to $350 billion by mid-2024. This growth was driven by $45 billion in new inflows and $105 billion in price appreciation.
Source: EPFR, Bloomberg
A substantial portion of these inflows was directed toward the United States and India, with the US receiving 33% of the flows ($15 billion), and India receiving 23% ($10.3 billion). The remaining 45% of the flows ($20 billion) were channeled into global funds, predominantly comprising US stocks. This period saw Yen-denominated assets in global equity funds grow by 75%, indicating a robust demand for risk assets funded by Yen borrowing.
In the United States, the majority of the Yen inflows were directed toward large-cap funds, while in India, a notable 25% of these flows were allocated to mid-cap funds. Interestingly, almost all of these inflows were into long-only funds, with minimal investment in exchange-traded funds (ETFs). This indicates a strong conviction among investors regarding the growth prospects of the underlying equities.
The Impact on Indian Markets
India has been a significant beneficiary of the recent Yen carry trade. Since January 2023, India’s Yen-denominated assets have increased from $6 billion to $21 billion, reflecting a 251% surge. The sharpest growth in assets under management (AUM) was observed in India, driven by retail investors, with a significant portion of these flows going into mid-cap funds.
The mid-cap segment of the Indian market saw an exceptional rally, with the Midcap Index appreciating by 42% between April and September 2023 without any significant corrections. This period coincided with the peak of Yen inflows into mid-cap funds, highlighting the direct impact of global liquidity on market performance. However, by October 2023, the incremental flows into mid-cap funds had halted, signaling a potential slowdown in this segment.
Source: EPFR, Bloomberg
Why Does Carry Trade Unwinding Happen?
Unwinding of carry trades typically occurs when the risk associated with the investment increases or when the interest rate differential narrows. In the current environment, several factors have contributed to this:
- Interest Rate Expectations: If investors anticipate that Japan might raise interest rates or if they expect interest rates elsewhere to fall, the attractiveness of the carry trade diminishes.
- Market Volatility: Increased global uncertainty or financial market volatility can lead investors to reduce risk by unwinding carry trades.
- Exchange Rate Movements: If the yen starts to appreciate significantly, the potential losses from currency movements can outweigh the gains from the interest rate differential, prompting investors to unwind their trades.
The Risks of Yen Unwind: Learning from the Past
The history of Yen carry trades provides valuable insights into the potential risks of an unwind. The last significant Yen carry trade in India occurred between March 2016 and January 2018, during which the Yen depreciated by 16% against the Indian Rupee (INR). This period witnessed substantial inflows into Indian equities, particularly mid-cap funds, leading to a broad expansion in market breadth.
However, the subsequent unwind of this trade, which began in January 2018, had severe consequences for the Indian market. The Yen appreciated by almost 30% over the next two years, causing a sharp contraction in market breadth, particularly in the mid and small-cap segments. Despite this, domestic mutual fund (MF) inflows remained positive, albeit with slowed momentum.
Source: EPFR, Bloomberg
The current Yen carry trade cycle, which began in March 2023, appears to be following a similar trajectory. The inflows into mid-cap funds have been even more pronounced, accounting for 25% of total flows. This has also triggered increased domestic MF inflows into mid and small-cap schemes, driven by price momentum. The average monthly small-cap flows since March 2023 are 1.5 times higher than the average of the previous two years.
Implications for Global Markets
The unwinding of the Yen carry trade poses a significant threat to global markets, particularly in the United States. The polarization of the US market since January 2023, where the weight of the top 10 stocks in the S&P 500 Index increased from 24% to 36%, has been largely driven by Yen-denominated flows. This has resulted in the S&P 500’s weighted index underperforming the equal-weighted index by 7% in just a few weeks, the sharpest divergence since 2020.
The biggest risk of the unwind would be in the top-heavy segments of the market, particularly in the S&P 500 Index’s top 10 constituents. Early signs of this reversal were observed in the latter half of 2023, underscoring the vulnerability of these high-flying stocks to a sudden reversal in capital flows.
Moreover, the impact of the Yen carry trade is not limited to equity markets. The resultant volatility from the unwinding of these trades could spill over into currency and bond markets, exacerbating global financial instability. The BOJ’s pledge to refrain from hiking interest rates in the immediate aftermath of recent market volatility indicates the central bank’s awareness of the potential risks. However, if the unwind accelerates, it could trigger a broader risk-off sentiment across global markets.
The Road Ahead: Navigating the Unwind
As global markets brace for the potential unwinding of the Yen carry trade, investors and policymakers must navigate this complex landscape with caution. The lessons from the 2018-2020 period, when India and the US experienced significant market disruptions due to Yen outflows, highlight the need for vigilance.
For investors, diversification across asset classes and geographies could be a prudent strategy to mitigate the risks associated with the Yen unwind. Additionally, monitoring the movements of the Japanese Yen and the BOJ’s monetary policy will be crucial in anticipating potential market shifts.
Policymakers, on the other hand, may need to consider measures to stabilize markets in the event of a sharp reversal in capital flows. This could include interventions in currency markets or adjustments to interest rates to manage the impact on financial stability.
In conclusion, while the Yen carry trade has provided a tailwind for global equity markets in recent years, the potential for an unwind presents significant risks. The impact on markets like India, which have seen substantial inflows into mid-cap funds, could be particularly severe. As the global financial landscape evolves, staying informed and prepared for potential market shifts will be key to navigating the challenges ahead.