Most casual readers of the financial press will have come across a new term in the past few days: the “carry trade.” Many market commentators and journalists are of the opinion that this is the cause of the market's rollercoaster ride.
In fact, it also triggered the credit crunch and subsequent global financial crisis of 2007-2008. Should we fear a repeat of that? This time the answer is yes and no.
The current turmoil began on Friday, August 2, when U.S. stock markets fell after new job creation numbers for July came in lower than expected. Japan's stock market then took an even bigger hit on Monday, with the country's main stock index, the Nikkei, posting its biggest one-day drop on record. Since then, stock markets have been tumbling up and down as traders and investors try to make sense of what's going on.
So why is carry trade getting a bad rap? First, a quick explanation of how it works. Carry trade is a financial strategy used by professional and amateur investors in the currency markets to exploit the interest rate differentials between countries to make a profit. Investors borrow money in a currency with a low interest rate and invest it in a currency with a high interest rate to make a profit.
Investors have become enthused about this strategy in recent years, borrowing cheaply in yen in Japan, where interest rates are still low (0.25%), and investing in places with higher rates, such as the United States (5.25% to 5.5%) and Mexico (10.75%). Researchers at Swiss bank UBS estimate that more than $500 billion in U.S. dollar-yen carry trades have taken place since 2011.
Nikkei Stock Average, 2023-24
Trading View
It is possible to make a steady, huge profit from the interest rate differentials on borrowing money without risking any of your own capital up front. But it's more like collecting pennies in front of a looming market crash. Every now and then, there's a carry crash, when currencies and interest rates fluctuate enough to make trading unprofitable.
At this point, capital flows stop. Asset bubbles, inflated in value by cross-border flows, then pop. This ripples through the financial system, affecting the availability of credit for trading parties. As even small losses begin to add up, lenders start asking investors to put up more cash to cover potential losses.
The process began in recent days and is cited as one of the reasons why Japanese investors have rapidly sold off their domestic stocks, dragging them down across global stock markets.
Financial history supports the idea that we should worry about these carry crashes: in my latest book on the history of financial crises, Calming the Storm: The Carry Trade, the Banking School, and the British Financial Crisis since 1825, I show how they have played a role in every major banking crisis in the UK over the past 200 years.
The yen-dollar carry trade also helped trigger the global financial crisis of 2007-2008. According to a 2009 paper by economists at the Bank for International Settlements, a global network of central banks, the withdrawal of yen funds from the United States by carry traders coincided with the start of the credit crunch in August 2007, when lending suddenly became unavailable across the financial system.
This led to a decline in asset prices, including collateralized debt obligations (CDOs), bundles of debt sold on the market by lenders. The CDOs that had previously attracted carry trader investments dried up, causing banks to run out of capital to raise capital. This situation continued into late 2007 and 2008, when the credit crunch turned into a full-blown financial crisis.
But while the carry trade is a concern, a softer landing is more likely than in 2007-08. The interest rate gap between Japan and the U.S. has narrowed slightly recently, from a previous gap of over 5% to just 0.15%. The only time we should really panic is if interest rates get much closer together.
In any case, in retrospect, the current market crash appears to have been caused more by poor US employment figures than by Japan's decision to slightly raise its policy interest rates.
And rather than being consistently awful, these jobs reports paint a mixed picture, suggesting it's not certain the U.S. is heading toward a recession and that investors may have sold off stocks more than they should have.
Last week's events should be seen as one of several market crashes resulting from interest rates surging around the world in 2022 and 2023, causing financial fragility. These include the panic caused by Chancellor Liz Truss' mini-budget in the UK in September 2022 and the collapse of Silicon Valley Bank in the US in March 2023.
Further turmoil is likely, but hopefully it won't be on the same scale as the financial crisis of 2008. For those involved in financial markets, either as investors or as investment recipients, this turmoil is not over yet.
Charles Read is a Research Fellow in Economics and History at Corpus Christi College, Cambridge.
This article is republished from The Conversation under a Creative Commons license. Read the original article.
