What is a carry trade? Lucrative to hold, but painful to unwind

Open full sized image

Portable currency, plenty of risk.

© Ljupco—iStock/Getty Images, © SimpleImages—Moment/Getty Images; Photo illustration Encyclopædia Britannica, Inc.

It’s one of the key components of capitalism: Accessing money as cheaply as possible and seeking the highest possible return. Companies issue stock and bonds to investors, then use the money to fund their business enterprises. Banks attract deposits from savers by paying interest, then loan it out at higher rates in the form of mortgages, auto loans, and business loans.

And some global institutional traders—such as hedge funds, investment banks, and proprietary trading firms—borrow money in low-interest areas of the world such as Japan and Switzerland, then invest in high-yielding (sometimes speculative, and frequently, momentum-driven) areas of the market.

This strategy is called a carry trade, and although it can be quite lucrative for those who can successfully employ it, fortunes can be lost in the blink of an eye if and when things start to unwind and traders scramble for the exits at the same time.

In any country, interest rates are a function of the economics within that country. If the exchange rate fluctuates due to inflation or other economic uncertainties such as civil unrest, drought, or political instability, the market will demand a higher interest rate to compensate. Central banks such as the U.S. Federal Reserve, Bank of Japan (BoJ), or European Central Bank (ECB) set short-term interest rate targets—and may try to influence longer-term rates by buying and holding securities on their balance sheets. 

In other words, at any given moment, you might see some countries with interest rates near zero and others upward of 8%. Carry traders—again, these are deep-pocketed investors and funds with a cross-border reach—use these interest rate disparities to initiate a four-step carry trade process:

Although Switzerland, Denmark, and a few other countries have had ultra-low—and, at times, even negative—benchmark interest rates, Japan has been the top carry trade choice for several decades. Why? The short answer: a commitment to low interest rates and currency stability.

As part of its occupation and restructuring of Japan after World War II, the U.S. helped build Japan into a global manufacturing powerhouse. By the 1980s, Japanese automobile, electronics, and other manufacturing-intensive industries led the world in terms of per capita output. The benchmark Nikkei 225 stock index swelled into a bubble that, when it burst in the early 1990s, sent Japan into a nasty deflationary spiral.

The BOJ pushed interest rates to zero (the “zero interest rate policy,” or ZIRP), and there they stayed. Because Japan lacks natural resources, its manufacturing advantage came from buying raw materials, efficiently turning them into finished goods, and selling them to the U.S. and other importing nations. To stay competitive, Japan needed to keep its exchange rate low in a process known as “competitive devaluation.” 

Because of its dependence on export sales, any hint of inflation—which would naturally drive up interest rates and thus the value of the yen—could threaten economic recovery and send prices and interest rates back down. Market watchers gave this phenomenon a name that sounded as though it were straight out of a Dr. Seuss book: the ZIRP trap. 

The yen carry trade has been supported by a seemingly endless supply of ZIRP-enabled currency to borrow and Japan’s commitment to keeping the currency from rising in order to maintain its export economy. Remember, after a carry trader borrows yen, they sell that yen to buy dollars, pounds, or other currency, depending on where they plan to invest.

There’s an old adage on Wall Street: “Don’t panic. But if you must panic, panic early.” It’s why, even in the era of deposit insurance and a highly regulated financial sector, we still see the occasional run on the bank. 

It’s also why, in late July and early August 2024, global investors got a quick lesson in the carry trade and what happens when carry traders are forced to liquidate positions. It all started with a small rate hike by the BoJ (from a range below 0.1% to roughly 0.25%) and a promise by the central bank that there would be more hikes to come. The yen shot up nearly 10% versus the dollar and other major currencies. At one point on August 5, Japan’s benchmark Nikkei 225 was down about 20% from the previous day (see figure 1). The mini-panic spilled over into the U.S. and sent stocks to their worst single-day move since the early days of the COVID-19 pandemic in 2020.

Open full sized image

Figure 1: WHEN UNWINDING IS NOT RELAXING. As inflation pressures pushed the Bank of Japan (BoJ) to embark on an interest rate hike policy, the carry trade began to unwind, then shifted into panic mode on August 5, 2024.

Source: StockCharts.com. Annotations by Encyclopædia Britannica. For educational purposes only.

That’s the chief risk of the carry trade—and any trade that’s backed by borrowed money (i.e., leveraged or “on margin”). When Japan’s interest rates (and currency) shot up at the same time markets were crashing, many carry traders found their positions underwater. They needed to sell any asset they could to raise cash for the dreaded margin calls. This reaction exacerbated the already painful sell-off. 

As a retail investor, you probably won’t participate in a carry trade—but when big traders are forced to unwind their deals, it can roil global markets, and you’ll want to be ready. Remember, when professional investors need to raise cash in a hurry, they’ll often sell their most liquid assets. And that could mean temporary bargains in some of your favorite stocks.

Keep your eye out for these occasional blowouts, keep your wish list handy, and be ready to jump when you feel the time is right.

Carry on.