Don’t Get Carried Away with Carry Trades

The recent, panic-laden unwinding of the yen carry trade demonstrates that perceived “easy money” can come at a high cost. Editor Murray Gunn recalls the 1998 dollar yen debacle, then discusses the recent episode and what to anticipate next:

One of the most popular trades over the previous couple of years had been the Japanese yen carry trade, where people had borrowed low-yielding yen and switched it into higher yielding currencies to pick up small but, believed to be, “stable” profit.

As the chart above shows, the yen carry trade was working well during 1997 and the first half of 1998 with USD-JPY stable to advancing (a depreciating yen) – key to carry traders who had borrowed the Japanese currency. As LTCM imploded from August, and buttocks around the world began to clench, USD-JPY started to decline. It wasn’t until October that panic truly hit.

A 17% crash in three days in a major foreign exchange pair was completely unprecedented and nothing like it has been seen since. People who had borrowed yen for the carry trade were left nursing heavy losses.

That was yen, this is now

The massive spike in financial market volatility at the beginning of August this year has, inevitably and lazily, been blamed by the financial media on people unwinding yen carry trades as a result of the Bank of Japan finally tightening monetary policy.

The yen had been appreciating since early July, well before the Bank of Japan’s decision at the end of the month which was not a surprise to anyone. Nevertheless, people who did have a yen carry trade on will have been very probably knocked out of their position as USD-JPY declined sharply.

This is the number one problem with carry trades. What you are doing in a carry trade is effectively selling volatility. And like any vol-selling game, you will win 90% of the time and lose 10% of the time. Unless you are very switched on and nimble, the 10% will wipe out the 90%. The good news is that Elliott wave analysis can keep you on the right side of trends and avoid crashes.

In the July issue of Global Rates & Money Flows (see chart below,) we had identified that USD-JPY was in the final advancing wave of a multi-year rally. After July’s key month reversal, it appears highly probable that USD-JPY is starting a sustained downtrend (appreciation of the yen). Adding to evidence that a multi-year peak is in place is the fact that the entire advance from 2011 to 2024 was a Fibonacci 13 years, and that waves W and Y were proportionate, lasting 44 months and 43 months respectively.

It’s the most volatile time of the year. Don’t let market action carry YOU out on a stretcher.

Follow the link below to read more Murray Gunn in Global Rates & Money Flows.