Fears of a violent halt to the global yen-focused trading strategy led to market panic on August 5. Markets have calmed down since then, but the threat has not disappeared. Estimating the size of a yen carry trade is not an easy task.
The trade that sparked the global financial panic on August 5 is alive and well, and it may soon haunt the markets.
That's according to a report on Tuesday by the Bank for International Settlements, an influential consortium of the world's central banks.
But how big is a yen carry trade? It's hard to say – and it depends on what you take into account.
Yen carry trade
Investors take advantage of Japan's low interest rates to borrow yen and buy high-yielding US equities and bonds – a strategy known as a “carry trade”.
The Bank of Japan threatened to make trade unprofitable when Japan raised interest rates to combat inflation. The August 5 crash was caused by investors selling their US assets to pay interest on borrowed yen.
On that day, Japan's Nikkei and TOPICS — the country's two biggest stock market indexes — fell more than 12%, marking their worst day since 1987. The S&P 500 and Nasdaq fell 4.2% and 6.3% during the same period.
Responding to the panic, the BoJ said it would not raise rates any further than it already has, and markets calmed down.
But the Federal Reserve could rekindle the crisis by announcing that rate cuts in the US are imminent, as the move would narrow the dollar-yen interest differential just as surely as a rise in Japanese rates.
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That doesn't bode well for crypto: Bitcoin and Ethereum fell 15% and 20%, respectively, on August 5, and the yen could react similarly if the carry trade is violently halted again.
BIS estimate of $764 billion
Estimating the size of the yen carry trade is no small feat – even the BIS is struggling with it.
The problem arises from the range of ways traders can execute trades. For example, firms outside of Japan may borrow yen from Japanese banks to invest these funds. Or foreign exchange traders can simply short the yen using derivatives.
Yen-denominated loans to nonbanks outside Japan stood at about $250 billion in March, the BIS said. A consortium of cross-border debt instruments issued by nonbanks in offshore centers puts that number at about $500 billion.
In addition, funds repatriated by foreign banks in Japan to their headquarters overseas are valued at approximately $90 billion.
Hedge funds, meanwhile, may have deployed up to $160 billion in over-the-counter yen derivatives, the BIS said. And net short positions in yen futures reached about $14 billion, although that trade was completely depleted on Aug. 5, the report said.
So far, this brings the yen carry trade to about $764 billion — at least before the crisis — although, according to the BIS, that figure is a significant underestimate as large gaps remain in the data.
The number does not take into account, for example, different methods of executing currency trades using off-balance sheet derivatives.
This does not include the suspension of retail traders' positions by margin brokerage platforms, which affected bitcoin and ethereum, the offshore Chinese renminbi, the Malaysian ringgit, the Mexican peso, the Brazilian real and the South African rand.
JP Morgan and Arthur Hayes
Analysts at financial giant JPMorgan Chase took a more conservative approach to calculating the yen carry trade.
Considering only spot currency trades, the investment firm said in an Aug. 7 report that 75% of trades were eliminated from the market during the crisis.
While JPMorgan did not give an estimate for the scale of the strategy, its narrow definition of the yen carry trade – and its claim that it is now largely undiminished – provides a very different perspective from the BIS calculations.
On the more extreme side of the equation, BitMEX co-founder Arthur Hayes Said Japan is running $24 trillion worth of risk on the yen carry trade.
Citing numbers taken from a Deutsche Bank report, Hayes said the Japanese government's balance sheet is six times the country's gross domestic product.
This includes Japan's $15 trillion in liabilities, which it uses to borrow the yen and fund carry trades, and $9 trillion in assets. Of these assets, nearly $2 trillion is invested directly in foreign securities.
But domestic debt, securities and equities — the bulk of the government's remaining assets — will perform well even in a low interest rate environment, Hayes said. And they benefit from the depreciation of the yen.
It's all relative
Estimating the size of a yen carry trade depends on what is being counted and who is doing the counting.
While JPMorgan analysts narrow the scope of their study to spot currency trades, the BIS looks at foreign debt and derivatives trading in its various forms.
Meanwhile, crypto's top macro expert, Arthur Hayes, uses Deutsche Bank to take a more holistic approach by looking at how the Japanese government funds itself while constantly devaluing its currency.
Tom Carreras writes about markets for DL News. Have a tip about the yen carry trade? Reach [email protected]
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