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For anyone who keeps an eye on the stock markets, Monday was a particularly bad day for investors. Near the worst, at the open, the Dow dropped 1,196 points, the S&P dropped 207, and the Nasdaq fell 924 points. So what happened? Just last Wednesday, July 31st, the Chairman of the Federal Reserve, Jerome Powell, held a press conference that affirmed inflation is coming down, the economy is cooling off but is still very good, no expectations or worries for a recession at this time, and there is foresight that they may be able to cut interest rates in the relatively near future because they can, not because they will have to. All good news.

The following day, Thursday August 1st, I remember seeing Sara Eisen on CNBC reporting something about concerns of an “unwinding Yen carry trade” as the stock markets were beginning to decline. Personally, I had no idea what she was talking about and didn’t give much credence to the Japanese yen having much influence over the U.S. stock market. (Just a note: Sara Eisen is a brilliant financial reporter well worth listening to.) Friday, the stock markets declines continued (not helped by a jobs report weaker than expected). Monday the stock markets, globally, had a meltdown.

Boy, was I wrong. What is happening? Why is this Yen thing wreaking so much havoc? Let’s ask AI to explain it:

The Yen Carry trade is a financial strategy where investors borrow Japanese yen at low-interest rates and then invest that borrowed money in higher-yielding assets elsewhere. Here’s how it works:

1. Borrowing Yen: Investors borrow yen at near-zero interest rates in Japan.
2. Investment: They redeploy the borrowed cash into assets with higher returns, such as stocks or bonds in other countries. (This also includes redeploying the borrowed cash into other countries’ higher-yielding currencies, commodities, real estate or any other asset, including risky speculation.)
3. Profit: The goal is to earn the difference between the low yen borrowing cost and the higher returns from the invested assets.

However, when the yen appreciates (gains value) against other currencies, it becomes more expensive to pay back the yen-denominated loans. Recently, a rate hike by the Bank of Japan triggered a surge in the yen’s value, leading investors to unwind their carry trades and causing market turmoil¹². Essentially, the yen carry trade is a balancing act between low borrowing costs and currency exchange rate fluctuations³. [CoPilot – italicized only]

At the Bank of Japan’s last meeting on July 30-31, they decided to hike their short-term interest rates from 0-0.01% up to 0.25%. At this point in time, the currency exchange rate of the Yen was at a 38-year low against the U.S. dollar, and this is reported to be why the BOJ raised interest rates; to prevent the value of the Yen from falling further. And it is reported that this was not unexpected. BOJ Governor Kazuo Ueda, however, explained the move as being prompted by rising prices and wages in Japan, i.e. inflation. The Japanese Nikkei stock market dropped over 18% in the 2 trading days since the BOJ raised interest rates

Typically, interest is charged on a carry trade loan daily, so all carry trades involving borrowing Yen just became less profitable overnight. The logic follows that the Yen borrowers are incentivized to repurchase Yen in order to close out their more expensive loans. Many traders may become subject to a margin call due to higher costs and be required to shore up their accounts to meet their maintenance levels. As demand for Yen increases, the relative value of the Yen increases. Incidentally, this also makes Japanese exports more expensive.

Carry trade borrowers will often sell higher risk assets, like stock, in order to pay for the Yen they owe the lender or to satisfy their margin requirements. It is estimated that around $4 trillion is of Yen is involved in carry trade [Perplexity AI] Unfortunately, several large financial firms are reporting that this “unwinding” is only about half-way done. Yet other money managers, such as Ed Yardeni, expect the carry trade selloff to be short-lived.

Today, Tuesday August 6, looks much different. The U.S. stock markets and the Nikkei are all up nicely. It will be interesting to see how the Yen carry trade plays out.