Towards the end of July 2024, the Central Bank of Japan raised their interest rates by a 15 – 25 basis points. This is a big deal because Japan has had its interest rates at near zero since 1999.
During the first weekend of August 2024, this lead to the unraveling of the Yen carry trade. So what is the the Yen carry trade? It works as follows:
Investors borrow in Japanese Yen at close to 0% interest.
Then you convert it into another currency, or invest in stocks, get some appreciation, then you liquidate the stocks, and you pay back your debt. The goal is to return a higher rate than the cost of borrowing the Yen.
Here’s an example of the flow of it:
A safer (less risky) way to do this is that you borrow Yen at ~0% interest and invest in a U.S. T-bill* that’s paying you about 5% (at the time of writing), pay back the loan and you pocket the difference.
*A U.S. T-bill (Treasury Bill) is a short-term government debt obligation backed by the U.S. government, sold at a discount and redeemed at maturity for its full face value, effectively serving as a risk-free investment with terms typically ranging from a few days to 52 weeks.
Keep in mind that you don’t really make a lot of money in this kind of trade. If you have a million dollars in Yen, swap it to US Dollars, put it in T- bills, you only make about 50k USD, which is not moving the needle. The way you make a lot of money with this approach is to leverage up this trade.
What people (typically hedge funds) do take e.g. a billion dollar and then lever it up 5-10x. The problem is that you are typically posting various kinds of collateral as margin to the banks, in order for them to give you that leverage. When these kinds of trades go wrong, which typically happens very suddenly and rapidly, it puts pressure on all other asset classes, as people are scrambling to make sure that they don’t get margined out (margin called).
In the case of the first weekend of August, some people had 100+ billion dollars of which they had maybe 5-10 billion of equity, while 80-90 billion dollar was just margin and then the rate hike unraveled those positions, which caused this very quick and hectic cycle. All of those people and hedge funds had to cover those trades, which meant that they all had to sell assets at the same time. That is what caused this acute chaos in the markets, in which the NASDAQ went down 6%.
Algorithms acting automatically and near instantaneous typically on behalf of hedge funds, in the middle of all of this chaos, sold about $41 billion of global equities, which causes everybody else to have to react and then they sell billions and billions more.
Imagine you have some asset that backs up your loan such as your house or your bank account. In these cases, large companies or hedge funds might have cash or equities to back up their loans. If they suddenly have to pay the loan, they are forced to liquidate it and in some cases those assets are controlled by the bank giving the loan and they will just start selling the shares you hold and whatever else you have posted as collateral to pay down that margin. This is a margin call, and can be quite detrimental.
A civilian can typically borrow e.g. $500,000 against their $2 million house in home equity. While rich people, large companies or hedge funds can borrow 10 – 20 times the value of the assets, which then could lead to absolute chaos if they are being margin called, across large numbers of such investors at the same time.
The Aging of the Japanese Population
The aging of the Japanese population is a major problem for them. In 1950s the average age in Japan was ~21 years old, while today it is ~48 years. In the next decade it will be 50 years, then 52 years, etc. That means more and more people are relying on public pension. Today 33% of their government spending goes towards their social Security Programs. For comparison, in the US, Social Security is about 20% of federal spending. That number is only growing larger, and as the population ages the Japanese government has to continue to service their older population.
Japan’s Debt
One of the largest challenges that Japan faces is the level of debt that they have recruited. Their debt to GDP ratio is currently 263%. They have about 1.3 quadrillion Yen of public debt on an annual GDP of about 591 trillion Yen. 25% of GDP per year is being spent just on servicing the existing debt and that is at interest rates set by the Central Bank of slightly above 0%. And, and they have got to support an aging population.
If the Central Bank of Japan had to start to raise rates because inflation started to run away, due to there being so much Yen in circulation, there is so much debt outstanding that the federal government would not be able to actually service their debt(!) Then their federal spending gets compressed because now they have to service that debt. As an analogy, the US debt service costs are well over a trillion a year with a proposed 7.3 trillion budget, so the US is at 13.6%. Over the next 10 years as all of the low interest bonds mature, and the US issues new debt at a higher interest rate, the US debt service cost is going to continue a climb. It is already higher than discretionary military spending, at over a trillion a year.
As of March of 2024, the Central Bank of Japan actually holds 53% of Japan’s outstanding government bonds, which is equal to about 100% of Japan’s GDP. In other words, the Central Bank of Japan has bought the debt that is being issued by the federal government, to fund their budget. A large chunk of which is being spent just on paying the interest on the debt, while interest rates are close to 0%.
Imagine if interest rates bumped up to 1, 2, 3, 4 or 5%, as we are seeing with US treasuries. Recently it was nearly at 5% on the 10-year treasury bond. It would become an unsustainable debt burden for the Japanese government to be able to handle that. A large part of this is being driven by a number of crises that Japan has faced since the early 1990s. There was the financial crisis in 2008, the Fukushima incident, etc. A lot of debt has been taken on to support the country after those crises.
Their debt has ballooned to a level that is well beyond any other industrialized nation. The only way to continue to service that debt economically is to keep interest rates low. While the problem with keeping interest rate low, is inflation. Inflation is the big driver that caused them to just recently (August 2024) increase the interest by 15 – 25 basis points. Clearly the market can’t deal with it, so Japan is in a really tough spot.
It goes to show how much having a large amount of federal debt can impact the ability for a nation to maneuver itself during difficult times. Ultimately debt payments come due. They come due either in the form of economic contraction, massive taxes or inflation. Currently Japan is paying for it in terms of inflation.
Japan’s inflation hit a 40-year high and this just shot up in the last 18 months. Inflation is running at close to 4% a year. They need to raise rates in order to reduce inflation. Their Central Bank has to buy most of the debt and their Central Bank sets the rates. They have a large amount, 53%, of their public debt held by their Central Bank. If they don’t pay a high interest rate, then people don’t buy future bonds. If they raise it, they have to pay that rate. This is the conundrum.
Japan has been in this kind of state since the 1990s, which lead to a massive property and equity bubble collapse and they have not had to deal with anything that looks like typical economic issues since then. Part of it is because the government plays a very big hand in the Japanese economy. There is a lot of price controls there.
Future State of Japan and the Yen Carry Trade
The reason why the Japanese Central Bank tried to raise rates by this tiny amount was because they are dealing with inflation. Japan’s inflation was roughly 0% in about 2012. At that point, the exchange ratio between the US dollar and the Yen was roughly so that 1 US dollar could buy 100 Yen. Now, it is at roughly 150 Yen to the dollar. In other words, the Yen has massively depreciated over the last several years.
A big part of the reason why is because the Central Bank of Japan is offering roughly zero interest and you can earn 5% in U.S. T-bills. Thus, people are basically moving their money to countries that pay a lot more on their bonds, and they are borrowing Yen to do so. Then they buy Australian dollars or US dollars to invest the money. This creates a huge downward pressure on the value of the Yen. Since Japan is an island that has very few natural resources, it needs to import a lot of resources, so as its currency depreciates the price of all those commodities goes up. Thereby driving inflation, and is why we are seeing inflation in Japan now.
When the Central Bank tried to solve this (by raising the interest a tiny bit), it created huge ripples in the financial market because it was starting to unwind the whole Yen carry trade, which amounts to about 20 trillion USD. As a result, the Central Bank of Japan backed off and the Japanese Central Bankers said we can’t raise rates while it would create instability in the global markets. We have to wait until it is stable. However, the problem is that raising the rates and unwinding the Yen carry trade creates the instability. This translates to them saying that are never going to be able to raise rates, and the result of this is going to be more inflation in Japan. Consequently, their currency is going to continue to depreciate, as they are unable to defend it.
What can be expected is that US dollars is going to keep being used to buy more Yen, and it is going to go increase from 150 Yen to the dollar moving forwards.
The Japanese consumer is going to be stuck paying the price in all of this, as prices of goods and services inflate. It will be good for tourism, but devasting to the Japanese national consumers as their purchasing power continue to erode.
On the back of this, one might expect big domestic problems in Japan and eventually they may conclude that this system does not benefit them.
However, one could argue that it benefits the United States because it has subsidized the purchase of US debt. A lot of the Yen carry trade of 20 trillion USD has gone into US bonds or US T-bills, so it basically is a huge subsidy to the US treasuries. The US need to continuously issue more and more debt and we are issuing to the tune of one trillion dollars of net new debt every 100 days, so having the Japanese consumer subsidize all of this in terms of inflation in order to provide this Yen carry trade has been very beneficial to the US Treasury.
The unraveling of the Yen carry trade shows the fragility of the Global Financial system. As soon as Japan declared that they could not defend their currency and had to let inflation increase (by not raising rates), the market snapped back. If the Yen carry trade were to end because e.g. the Japanese people don’t want to experience hyperinflation, then what would that do to the global economy..? It just showed how rickety the whole system is, and how much leverage there is in the system.
Based on the high levels of leverage that hedge funds are able to put in motion, it would be a good idea to increase regulation or increase scrutiny of leverage ratios. After all of the chaos of the Great Financial Crisis, we have kept running the same, if not more risk. We just took it off balance sheets. The banks were able to structure business lines to work with these hedge funds and these hedge funds in turn were able to show over time that they are so tightly managed that there are no Black Swan events that could happen. That they can run highly leveraged. We now find ourselves in a moment in which we are likely to experience these fissures from time to time.
The Yen carry trade is going to be put back on. In fact, now is even better time (than prior to the unraveling) to put that trade on because the bank of Japan basically just capitulated and said that they can’t raise interest rates while things are so unstable. Thus, we know they are just going to keep rates where they are(!)
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Disclaimer
I’m not a Financial Advisor, nor do I play one on the internet. All investments have risk. Do your own research and come to your own conclusions, and consult your financial advisor before making any investments.
📚 Sources and References
- Japan Interest Rate
- The Yen Carry Trade Explained
- Japan: Median age of the population from 1950 to 2100*
- Japan’s consumer inflation hits fresh 40-year high, eyes on BOJ policy
- Japan’s yen fell to a 34-year low against the US dollar
- Bank of Japan Walks Back Talk of Rate Increases After Roiling Markets
- All-in Podcast episode #191
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