The Market Follows the Yen Carry Trade

The Wall Street Journal reports that the yen hit a three-month high against the dollar today. Combined with the yen's rise against other currencies and volatility in global markets, investors rushed to unwind yen carry trades.

Many market oracles contend that the fine difference between a boom and its busting rests on movements in the yen carry trade. The yen carry trade is borrowing in countries with low short-term rates like Japan and investing in higher yield assets in nations with higher rates, like the US. As long as exchange rates stay constant, you net the difference in interest rates. Compounded by leverage, you net considerably more.

When the yen rises sharply against the dollar (check), and US Treasuries dip (check), huge losses can result from carry trades (in 1998, this was a major reason for the LTCM collapse). Carry trades are major source of cheap funding and global liquidity, and a sudden unwinding in the carry trade creates a feedback loop that augments existing credit concerns and often results in negative movements in equity markets.