Riding the Waves of Market Volatility: Understanding the Yen Carry-Trade Unwind
The third quarter of this year witnessed a rapid surge in yen appreciation that sent shockwaves across major asset markets, sparking both chaos and concern among policymakers. The unwinding of yen carry-trades, estimated at several hundred billion dollars, set off a domino effect of forced liquidations as currency gains increased the costs of repaying yen loans funding non-yen investments. This led to a frenzy of selling non-yen assets to settle debts, exacerbating the yen rally and causing turmoil in local currency assets.
While market sentiment eventually stabilized and volatility subsided, the episode shed light on the risks posed by carry-trades, especially those reliant on institutional foreign currency borrowing. This so-called “plentiful liquidity” illusion, fueled by a blend of sticky money supply and transient flows, may have overstated the resilience of the financial system and the depth of the market.
Renowned investor Warren Buffett once famously remarked, “You don’t find out who’s been swimming naked until the tide goes out,” alluding to the exposure of vulnerabilities during turbulent times. The transitory liquidity from carry-trades had artificially propped up market levels, providing a false sense of security until the tide turned in the third quarter of 2024, revealing the fleeting nature of borrowed liquidity.
Fungible Money Sustained Buoyant Asset Prices Despite Rate Hikes
In a subsequent interview, BIS Economic Adviser Hyun Song Shin delved into the implications of the yen carry-trade unwind. Prior to the upheaval, asset markets were fueled by institutional currency borrowing, such as FX swaps that facilitated the flow of cheap liquidity from regions like Japan to higher-yielding markets like the United States.
While FX swaps were initially used for currency hedging, they evolved into a tool for converting borrowed cash into foreign currencies, with institutions leveraging these funds to participate in yield-seeking activities. This borderless movement of liquidity across markets, facilitated by FX swaps, blurred the lines between local monetary policies and global financial flows.
Shin’s analysis highlighted the disconnect between domestic liquidity conditions in the U.S. and the global volatility triggered by carry-trades. The fungibility of money across currencies eroded the impact of local monetary measures, allowing institutions to circumvent funding constraints and influence markets beyond national borders.
Borderless, Flighty Liquidity Complicates Policy Transmission and Heightens Market Volatility
Within contemporary central bank frameworks, asset prices play a crucial role in transmitting monetary policy to the economy. However, the presence of substantial carry-trade flows introduced noise in policy transmission, making it challenging for central banks to navigate the influence of global liquidity on local financial conditions.
Furthermore, the asymmetrical impact of carry-trade inflows and unwinds on policy stances added complexity to market dynamics, leading to heightened volatility and uncertainty. Euphoric rallies driven by inflows and panic-induced asset routs fueled by unwinds created a precarious balance between euphoria and panic.
As we navigate the ever-evolving landscape of global finance, understanding the intricacies of carry-trades and the implications of fungible money on market stability is crucial for investors and policymakers alike.
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Disclaimer: The views expressed in this post are solely those of the author and do not constitute investment advice or reflect the opinions of CFA Institute or the author’s employer.
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