What the Heck Is a Carry Trade?

After a few days of floundering about, the chattering class has determined that the recent market turmoil is due to a change in the "yen carry trade." That's all well and good, but it occurs to us that many individual investors might not have the slightest idea what a yen carry trade is, and just how it would impact their stocks. ("Yen? What do yen have to do with my companies?") We thought we'd boil down this gobbledygook into language that might make a little more sense, so the next time someone mentions the carry trade, you won't be left to nod your head sagely without really knowing what the heck they're talking about.

How to win at a shell game
But we're getting ahead of ourselves. Let's talk basics for a moment. A carry trade occurs when a speculator borrows in one currency and trades in another. Few markets have been riper for carry traders than Japan, because of a depressed yen and near-zero borrowing costs. This condition has been in place for years, a result of nearly two decades of recession in Japan. To spur economic growth, the Japanese central bank has kept its prime lending rate at essentially zero.

Many large investors have taken advantage of the free money to borrow hundreds of billions of yen, using that money to invest that capital worldwide. Why borrow dollars at 4.5% in the U.S. when you could use yen at 0.25%?

That strategy could surely make you rich in a bull market. So long as rates remained cheap and the spread between the rates remained large, the resultant higher liquidity would fuel demand for equities, which, in turn, would lead to higher stock prices worldwide.

But when borrowing gets more expensive, or the spread starts to close ... Well, that's when the problems begin. Here, we're talking about an estimated $1 trillion in borrowed funds via yen-driven carry trades invested in thousands of income and equity securities in dozens, if not hundreds, of global markets. So when the Japanese central bank raises its rates to a still-paltry 0.5%, and the vice minister of the Ministry of Finance, Hiroshi Watanabe, says they may continue to rise, what's the most reasonable response among investors whose borrowing costs are rising? They start dialing back their risk by selling off assets.

If investors all try to hit the exits at once, you have the potential for a market dislocation. As with everything regarding financial assets, things don't seem to matter that much, until suddenly nothing matters more.

Meanwhile, in London ...
Which brings us back to the regulators. Earlier today, Watanabe urged investors to consider the high level of risk inherent with leveraged carry trades.

Smart. But what came next was inexplicable, to us at least. Watanabe told the group of G-7 ministers gathered in London that the damage from a reversal would be limited because most of the borrowed money is invested in overseas housing loans. That sounds reasonable enough, if only because mortgages aren't the most liquid of financial instruments. Trouble is, Watanabe said he had no statistics to back up his thesis.

What we do know is that the perpetual money-minting machine of the yen carry trade has finally bitten back. Where folks once used the carry for simple arbitrage between the yen and other currencies, they've worked their way up the risk curve -- for example, piling into stocks in China and India. Think the fact that the recent weakness started in China is a coincidence? Neither do we. When the spread tightens, investors dial back risk. That means companies like China Mobile (NYSE: CHL  ) and Tata Motors (NYSE: TTM  ) suddenly come under some real pressure as liquidity gets sucked out of their markets.

The yen surged 2% versus the U.S. dollar on Tuesday, its largest one-day gain in 14 months. We've no way of knowing whether the currency will continue its climb. Nevertheless, the uncertainty adds risk for traders who, until now, have been certain the yen would remain weak.

Meanwhile, the Japanese central bank did recently raise the prime interest rate from 0.25% to 0.50%. Watanabe told those at today's G-7 meeting that rates would rise again, further increasing the risk faced by folks who've financed investments outside Japan in yen. Who are some of these folks? Throw a rock at any large international bank -- Goldman Sachs (NYSE: GS  ) , Credit Suisse (NYSE: CS  ) , Merrill Lynch (NYSE: MER  ) , UBS (NYSE: UBS  ) and HSBC (NYSE: HBC  ) . No one will know for a while if this is the end of the yen carry trade, or if it will survive for many more years. When its time comes, there could be a great deal of market dislocation.

We're likely to know a lot more in the coming days and weeks. Bill and his team at Global Gains will be monitoring the situation closely throughout. Till then, remember that speculation, while a part of investing, can hurt your portfolio even if you're not the one doing the speculating. That's the real lesson when it comes to carry trades.

Global investing can be a great way to beat the market. But thanks to carry trades and other craziness, it carries a high degree of risk, which makes getting help a good idea. That's why Bill started Global Gains. Click here to try the service free for 30 days. There's no obligation to subscribe.

Neither Bill Mann nor Fool contributor Tim Beyers owned shares in any of the companies mentioned in this article at the time of publication. The Motley Fool's disclosure policy is comfortable wherever your portfolio wishes to travel.


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