A Reversal, Finally

Decades of current account surpluses have given Japan the world's largest net international investment position, with USD 3.3 trillion of investments held abroad. Although, America may have the largest economic influence in the world, Japan plausibly has the most sway in asset markets, due to these account surpluses. Should the Bank of Japan (BoJ) begin to substantially tighten monetary policy next year, the potential for a reversal of decades of outward capital flows will affect investors across the world. This phenomenon of borrowing cheaply in yen and investing in US and emerging market assets, in higher return instruments, is called the yen carry trade. Reversals have the ability to shock asset prices everywhere, but specifically in tech stocks, which have received the largest investments. 

The yen rose 14% against the dollar in less than a month causing assets to decline in value, against yen-denominated borrowings used to fund those purchases. This compelled investors to unwind their trades. The spectacular moves in markets on August 5, indicates the likelihood of forced selling. On July 31, the BoJ surprised markets with a bigger than expected rate hike and indicated further hikes together with quantitative tightening (reducing the assets on their balance sheet purchased during the decade-long period of quantitative easing). Additionally, worsening U.S. economic data and disappointing updates from some mega-cap tech companies, weighed on the dollar and stocks generally. Going long on tech and short on the yen, have been very popular in recent years. It has been possible to borrow at the cheapest interest rate in yen and invest in higher return assets including tech stocks and US treasuries.

Japanese funds are the largest overseas investors in US Treasuries and among the top five in ownership of non-Japanese stocks. The BoJ's current hawkish bias offers the potential for a reversal of more than a decade of outward flow of capital to be felt by investors worldwide. It is unlikely that all the outbound investment from Japan will reverse, yet, it may not be a one-way flow anymore with some capital repatriated to Japan over the coming quarters. The Federal Reserve may step in with an emergency rate cut prior to their scheduled September meeting. Although softer economic and employment data may prompt the Fed towards cutting interest rates, such a move is unlikely to halt the unwinding. An emergency cut by the Fed would tend to strengthen the yen against the dollar exacerbating the carry trade unwind.

The global stock market sell-off on August 5 saw a turnaround the next day when markets rebounded. The stock market recovery doesn't guarantee that the risk has been eliminated. The most dramatic moves tied to the unwinding of the short-term yen trade may have passed, but this cannot be the end of the saga. For over a decade money was cheaply borrowed in yen and may have been invested in risky assets like U.S. tech stocks. Ultimately, we have no way of knowing how long or how far the drag on stocks and currencies from the 2024 carry trade unwind could go over the medium or longer-term. Be that as it may, the most affected asset classes would be the most over-valued ones, as they were the biggest recipients of investments that were based on borrowings in the yen. Currently, the yen trades at about 147 to the greenback. At this exchange rate, Japanese consumers are hurting with expensive imports. We expect the yen to gain in value over the coming three years creating stronger incentives for further reversals in the carry trade. Expect volatility to continue across global asset classes.