Carry trade is a popular financial strategy that allows investors to profit from the interest rate differentials between different economies. Specifically, this strategy involves borrowing money in a currency with a low-interest rate, then investing those funds in a currency offering a higher interest rate. The goal is to make a profit on the difference between these two rates.
Here's how Japanese carry trade works. First, investors borrow money in the Japanese yen, where interest rates are very low, close to zero. Then, the borrowed funds are converted into another currency with higher interest rates, such as the US dollar. Investors then place these funds into financial instruments like bonds or bank deposits that yield a higher return. The profit is made on the difference between the borrowing cost (low-interest rate) and the investment return (high-interest rate).
For example, an investor might borrow 1 million yen at an interest rate of 0.1% in Japan. They would then convert these yen into US dollars to invest in US bonds offering an interest rate of 2%. The gross profit would then be 1.9%, the difference between the US interest rate and the Japanese interest rate.
However, carry trade is not without risks. The main risk is exchange rate fluctuations. Recently, the Japanese yen has strengthened, moving from just over 160 yen to 142 yen per US dollar. This is a direct consequence of the recent drop in US interest rates, combined with the fact that the Bank of Japan recently raised its key rate. This strengthening of the yen has likely eroded gains or even turned them into losses for investors using this strategy.
This can partly explain why the Nikkei 225, Japan's main benchmark index, has lost 12.4%, its largest daily drop since 1987. To give an idea of the magnitude of this volatility, the volatility index of this index has climbed by 140%, as the image shows.
As a result, global stock markets are under pressure, suggesting a possible surprise reduction in the US key interest rate. There is about a 60% probability that such a cut will be announced within the next week.
For those looking to take advantage of a potential rebound in stock prices, it is recommended to closely follow the Japanese yen's chart against the US dollar. A stabilization of this currency pair could indicate a lower level of anxiety in the markets.
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