Today, I’ll look at how Japan’s interest rate hikes could disrupt yen carry trades and affect global markets. Let’s start with a story. Imagine three people. Two of them are really rich. One has a ton of money that he lends out at very low interest rates. The other has assets that make him even richer because they yield big returns. Then there’s a smart investor. He sees a great opportunity. He borrows from the first rich person at a cheap rate and invests it in the second rich person to earn more. The difference between what he pays in interest and what he earns is his profit.

Now imagine this happening globally. The first rich person is like Japan, offering loans in yen at very low interest rates. The smart investor is the one who borrows in yen, converts it into dollars or other currencies, and invests in assets that yield much higher returns. This is called a “carry trade,” and it’s a way to make money by borrowing cheaply from one place and earning more from another.

So how does this relate to today’s story?

Japan has been famous for negative and ultra-low interest rates for decades. Central banks such as the Bank of Japan (BoJ) have pursued policies such as printing money and keeping borrowing costs close to zero. This has made yen carry trades a popular and profitable strategy for countries and investors.

But things started to change last year.

You see, carry trades work best when the yen is weaker than the US dollar. This is because it is cheap to borrow yen and easy money to invest in higher-yielding US assets. But when the yen strengthens, this trade starts to fall apart. Because if you borrow yen, you will eventually have to pay that debt back in yen. A stronger yen means you will need more dollars to pay back the same amount of yen. This can either reduce your profits or turn it into a loss.

Which brings us to Japan’s latest moves. The BOJ has been signaling that it is done with super-low interest rates. Last year, in March 2024, it raised interest rates for the first time in years from -0.1% to 0.1%. Japan did this because inflation was returning. After years of falling or stagnant prices, global supply chain issues and higher energy costs have started to push prices up in Japan. In order to prevent inflation from getting any worse, the government decided it was time to tighten the screws by raising interest rates.

This surprised many investors as it was the first rate hike since 2007!

Not only that, the BOJ also announced a second rate hike to 0.25% in July 2024.

Just a few weeks after the hike, the value of the yen increased, forcing traders to quickly exit their current trading positions. This sudden move caused chaos in global markets, and falling stock and bond prices showed how fragile the system can be.

This was a big deal for carry traders.

They had been enjoying low costs and a stable yen for years (all easy money)! But as Japan raised interest rates, borrowing in yen became more expensive. Now, many think the BOJ’s next policy meeting could bring another rate hike, which could lead to more problems with carries.

But Japan isn’t the only player here. The U.S. is also shaping how these trades work.

In the U.S., the Federal Reserve spent much of the past year cutting interest rates. They lowered their target rate to a range of 4.25%-4.50% through the end of 2024, and hinted at further cuts in 2025.

How does this affect yen carries, you ask?

Lower U.S. interest rates make borrowing in dollars less attractive than in yen. So yen carry traders see a changing opportunity: As U.S. rates fall, the difference between borrowing yen and earning in dollars narrows. If the Federal Reserve cuts another rate, the appeal of investing in U.S. dollar-denominated assets diminishes. Investors may begin to question whether borrowing yen and dealing with potential currency risk is worth the diminishing returns. Of course, this can have a negative impact on the market, depending on how much carry trade there is.

Global markets are often concerned about carry trades because of how quickly they can deteriorate. When investors rush to repay their yen loans, demand for the yen skyrockets, pushing its value even higher. This can create a vicious cycle, with the yen strengthening further and markets around the world feeling the pinch.

This kind of chaos has happened before.

In 2007, during the “quantitative crunch,” yen carry trading collapsed and markets spiraled out of control. Hedge funds sold their assets in panic, the yen surged, and shockwaves hit stocks and bonds globally. Even last August, something similar happened when the BOJ raised interest rates, showing how sensitive the world still is to these trades.

They all tell us that yen carry trading is like a game of musical chairs. As long as the music is playing — with low Japanese rates and a weak yen — everyone makes money. But when the music stops, chaos ensues. Japan’s rate hikes could be like turning down the music, and investors will look anxiously at the chairs.

All in all, Japan’s decision to raise interest rates is a watershed moment. It could shake up the world of carry trading and send shockwaves through global markets. It could end the days of easy profits for carry traders. At least for a while, if not in the long term, it could give way to a more unpredictable and risky environment.

Still, it shows how deeply interconnected the global financial system really is.