The Bank of Japan increased interest rates last week on Wednesday (July 31, 2024) causing a sharp drop in Japanese stock indices and disruption in global markets.

This was the first interest rate hike by the Japanese Central Bank in 17 years, with the last one occurring in 2007. The BoJ raised its short-term policy rate from -0.1 percent to a range between 0 and 0.1 percent.

Due to this hike in interest rate, International markets on Monday (5 August, 2024) faced one of their biggest declines, where Japanese markets plunged by as much as 12 percent, their largest drop since 1987, driven by fears of an end to ‘carry trade’.

What is Carry Trade?

A carry trade is a popular investment strategy where an investor borrows money from a country with low interest rates and a weaker currency, and then invests that money in assets from another country that offers higher returns. This approach has been a significant driver of movement in the global currency market.

For example – Imagine you borrow money in Japan, where interest rates are very low, and then invest that money in the United States, where interest rates are higher. You earn money from the difference in interest rates between the two countries.

What is Yen Carry Trade?

The yen carry trade is one of the most common examples of this strategy. Investors, including everyday Japanese citizens, borrow money at Japan’s low interest rates and invest in higher-yield assets abroad, such as US stocks or bonds. This strategy has been particularly popular because Japan has kept its interest rates near zero for over 20 years, except for a brief period from 2006 to 2008.

For example – Suppose you borrow 1 million yen from a Japanese bank at an interest rate of 0.1%. You then convert this yen into US dollars and invest in US bonds that offer a 2% return. You profit from the 1.9% difference in interest rates. This strategy has been favored because Japan’s low interest rates make borrowing cheap, and the stronger dollar improves the potential returns.

How Does the Bank of Japan’s Decision Affect Traders?

The Bank of Japan’s decision to raise interest rates has a significant impact on traders who use the yen in their carry trade strategy in two main ways:

Increased Borrowing Costs: Higher interest rates mean that borrowing yen becomes more expensive. If the returns on investments made with the borrowed money do not increase as well, the profit margins for these trades will shrink.

Stronger Yen: Higher interest rates can attract more foreign investments into Japan, which can strengthen the yen. As a result, traders who need to repay their yen loans might face higher costs, as the value of the yen increases, making their repayments more expensive.

Also Read: Sensex, Nifty Crash Today: Top Reasons Behind Stock Market Mayhem on August 5, 2024

Impact on Stock Market

According to Nikkei Asia, Japan’s benchmark index, the Nikkei Stock Average, experienced its worst-ever daily drop on Monday (5 August, 2024) losing 4,451.28 points from the previous day’s closing.

The index closed down 12.4 percent at 31,458.42. In terms of percentage, this was the second-largest decline since the Black Monday crash in October 1987, when the index fell by 3,836.48 points (14.9%), marking the previous record drop.

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FAQs

1. What is a carry trade?

Borrow in a low-interest currency (e.g., yen), invest in higher-yield assets (e.g., U.S. bonds), and profit from the rate difference.

2. Why did the BoJ raise interest rates?

To combat inflation (Japan’s CPI hit 2.8% in 2024) and normalize policy after decades of ultra-low rates.

3. How does a stronger yen hurt global markets?

It forces investors to unwind carry trades, leading to sell-offs in bonds, equities, and emerging markets.

4. Which markets are most affected?

• U.S. Treasuries: Massive sell-offs pushed yields higher.
• Emerging Markets (India, Indonesia): Capital outflows weakened currencies.
• Commodities: A stronger yen reduced demand for dollar-priced oil/gold.

5. Will carry trades disappear?

No, but they’ll become riskier. Investors will seek currencies with steeper rate gaps (e.g., USD vs. EUR).

6. How can investors adapt?

• Hedge currency risks.
• Shift to equities or assets less tied to rate differentials.

7. Did the BoJ’s move surprise markets?

Partially—while expected eventually, the timing caught some off guard, amplifying volatility.

8. What’s the impact on Indian markets?

• INR weakened against the yen, raising import costs.
• FPI outflows pressured equities (Nifty fell 2% post-announcement).

9. Are central banks intervening?

Yes. India’s RBI sold dollars to stabilize the rupee; Japan may ease policies if the yen rallies too sharply.

10. Will the BoJ hike rates again?

Unlikely soon. Policymakers signaled caution to avoid destabilizing Japan’s fragile economy.