The Japanese yen has fallen sharply, exceeding 153 yen to the dollar for the first time since February. This has reignited concerns about the yen carry trade and its potential to cause global financial chaos.
The Bank of Japan faces a key choice: raise interest rates to support the plummeting yen, or maintain current policy and risk causing market turmoil. Experts have warned that the fallout from the policy shift could trigger a crisis.
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Turning point in the yen carry trade
In the yen carry trade, investors borrow in yen at low interest rates and use the interest rate differential to invest in high-yield assets overseas, such as U.S. stocks and bonds. For decades, Japan’s near-zero interest rates have made the yen an attractive funding currency.
What is noteworthy is that even small adjustments by the Bank of Japan are causing ripples in the market. For example, in July 2024, the Bank of Japan raised interest rates for the first time in several years, causing the yen to appreciate by 13% in one month.
But the move set the stage for turmoil in August, when Japanese stocks suffered record losses. According to Reuters, the Nikkei Stock Average recorded its biggest single-day decline since Black Monday in 1987.
“After raising interest rates by a quarter of a percentage point in early 2024, the Bank of Japan caught the market off guard with a second rate hike soon after. This triggered a significant appreciation in the yen, at one point sending the VIX above the 60 level and causing a roughly 10% correction in the S&P 500 index,” said analyst Michael A. Gade.
This volatility occurs because carry trades are highly leveraged. A sudden spike in the value of the yen or a change in interest rate differentials can cause panic to subside. Forced sales then reduce prices across the market.
However, the scale of today’s yen carry trades is much larger, with trade sizes estimated at up to $14 trillion, more than three times the market capitalization of cryptocurrencies. As the yen continues to weaken, risks will further increase.
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Analysts are calling this scenario a potential “black swan,” a rare and unpredictable event with global consequences. If the interest rate differential between Japan and other countries narrows further, rapid easing could amplify panic, with similar effects on bonds, stocks, and cryptocurrencies.
Policy impasse and political uncertainty
Meanwhile, the Bank of Japan faces a tough policy dilemma under Governor Kazuo Ueda. Raising interest rates could stabilize the yen, but given the interconnectedness of global finance, there is a risk that Japan’s bond market could collapse, which would spill over into U.S. stocks.
However, maintaining low interest rates will lead to currency collapse and hyperinflation. Political changes have increased uncertainty.
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Following Sanae Takaichi’s victory in the Liberal Democratic Party presidential election, investors reevaluated the outlook for monetary policy. The probability of a rate hike in October has fallen from 68% to 25% because he strongly opposes rate hikes.
Still, the responsibility of Bank of Japan Governor Kazuo Ueda is increasing. He will need to balance political pressure with maintaining the central bank’s independence.
Recent indicators highlight the growing risks. The yen carry trade indicator shows a bearish divergence, suggesting a possible reversal. Additionally, macroeconomist Kashyap Sriram suggested that without intervention, the yen could become the first major currency in modern times to collapse.
Therefore, this could lead to the Bank of Japan raising interest rates to rescue the weaker yen, despite political pressure.
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Cryptocurrency and ripple effects on global assets
Meanwhile, the impact of unwinding interest rate hikes extends far beyond stocks and bonds, putting cryptocurrencies at risk as well. Bitcoin (BTC) fell below $50,000 due to the August 2024 turmoil.
Analyst Ted Pillows said: “If rates rise, investors will sell global assets and exchange them for yen to pay down debt. This will create significant short-term selling pressure similar to August 2024.”
Therefore, if the Bank of Japan decides to raise interest rates again, Bitcoin could feel the impact in the coming months. While Q4 seasonality typically favors BTC’s performance, it is still possible that macroeconomic shocks due to liquidity tightness from the yen could reverse these trends.
So the fate of the world’s assets, from stocks to Bitcoin, now depends on Japan’s next move. Future yen policy will have a major impact on those involved in global capital markets, so investors are bracing for possible aftershocks.
