Carry Trades, Explained

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Hello from Hong Kong, David Gura, What hi, Hello from New York. It is great to talk to you across the ocean. And it looks like if I squint here and look at my zooms when you're having dinner in the.

Studio, very good eyes, I am. And it's at the heart of our episode today. It explains the rocking global currency markets. Right now, let me show you what I'm having so you can drool over it through zoom. You see here, see if you can see this, can you see?

I just look at that chopsticks in hand, and it looks like a dumpling. Is it a dumpling?

It is, But it's not just any dumpling, David. This is a Shao longboo, a soup dumpling, right. It's got yummy broth inside, and it's from a famous Taiwanese restaurant called Didn't Tai Phong. They've got branches in New York and here in Hong Kong, all over the world.

And let me get this straight. Their soup dumplings are behind what's rocking the global currency markets.

They are in a way. I'll let Shuley Wren explain she's a Bloomberg opinion columnist to covers Asian markets.

Yes, so the challona in it's kind of like the big mag indecks that tests out the purchasing power of the world's biggest the cosmopolitan cities. Ding Typhoon was expanding outside of Taiwan and the opening restaurants in the biggest, the most posh cities. And the idea is that if you look at the global cosmopolitans like Dubai, Hong Kong, Singapore, London, New York, the cost of Shallon Bau should be the same, and the it turns out they can be quite different.

So, David, we would have ordered you some dumplings from the DN Typhoon in New York apparently, but apparently they don't do takeout or delivery. And get this, you have to book seats at midnight a month and.

A month in advance. My gosh, how good are these dumplings?

They are very delicious. Luckily for us here in Hong Kong, they're much easier to get a hold of, so I use the equivalent of ten US dollars to buy Dntai Fung dumplings and I got around six shallong bows. Right, And even though we didn't manage to get dumplings delivered to you in the studio there, we did we will. At some point we did look up the price and get this, you'd only get about five dumplings.

Only five, only five.

But in Tokyo, once you traded your ten US dollars for Japanese yen, you'd get around eight dumplings.

Okay, So ten US dollars goes further in Japan, and I guess that's a sign that maybe the yen is just a little bit undervalued. Oh, I get it. This is all about all the carry trade news.

That's right. Carry trades, right, they're pretty technical inside market stuff. You don't usually hear it in the broader news. But recently a whole bunch of carry trades went south and took the markets with them.

Yeah. I've watched the value of the en rise quite a bit against the dollar, and that hammered a bunch of these trades.

That's right. Not mentioned it left a lot of investors with balance sheets that looked a little bit like, you know, the watery inside of a soup dumpling.

Here.

So today, as part of our ongoing series. Bloomberg explains, we're talking about carry trades, how they work, what went wrong, and why it hammered global markets.

I'm one huh, and I'm David Gerret and this is the big take Asia from Bloomberg News.

So, David, the news has been full of carry trades lately. They've been making a lot of headlines.

Yeah, they're new to a lot of people, but the trades themselves have a long history.

Here's Shuley renagain, a Bloomberg columnist who covers Asian markets.

Carrie trade has been going on for a long time. It's really simple. It's basically taking out cheap loans from countries that have very low interest rate, and then the investors in turn exchange it into another currency and invest in countries that have much higher yielding assets.

I've got to really simple example, David. Let's say I borrow one thousand dollars worth of Japanese in from a Japanese bank. Let's say you're that bank.

Okay, I'll lend you that one thousand, and I'm going to charge you a little interest for that loan.

And in Japan it's very little interest, right, So for a long time, the Bank of Japan's main interest rate was basically zero. Now, assuming I get that rate, I'll convert this money I've borrowed into US dollars and lend out that money at around five and a half percent, which is the rate in the US at the moment.

This sounds like a pretty good deal for you.

It is. Now, when the person I lent money to pays back my loan, I get back that one thousand dollars plus interest, let's say it's one thousand and sixty dollars.

Now you pay me back one thousand dollars I lent you, but I didn't charge any interest or very little interest. And assuming and this is a big assumption here, that the exchange rate stays the same when you pay me back, you get to keep that sixty bucks.

Right, not a bad profit?

Right, not at all. And that there is the appeal of the en carry trade.

It's got a funny name. Why is it called a carry trade?

It's an esoteric name. The traders like to use the word carry. Basically Carrie Mings earning interest rate differentials, and.

You're essentially carrying that until you make.

A profit, yes, like you're carrying a baby. It's like a pregnancy carry out baby.

A little profit baby, the kind the markets really love. As Shirley said, the carry trade has been around for a long time, but.

The most famous carry trades are done by the Japanese retail investors, the so called a missus u watanabe.

The so called missus watanabi refers to Japanese housewives. It's kind of hard to trace when the term started to first be used, but we do know that the newspaper The Economist popularize the current use in the late nineteen nineties. That's when the Bank of Japan, desperate to stimulate economic activity, turned to a policy of keeping interest rates near zero or even get this negative.

So the missis wanta nabbies, they will be actually managing the family wealth, right, and then they know that you cannot put money in the bank because you're not getting any interest in return. So what they do is that they invest their money in other countries, and they were actually quite adventurous. They will buy Mexican passle, Turkish lira, Indonesia, rupia. These are all the emergent market currencies that they can earn a higher interest rate from.

But it wasn't just the missus wattonabbies who saw opportunity with the weekend. The yen carry trade, in its various permutations, is now carried out by hedge funds, investment firms, and traders all over the world.

And these trades have only gotten bigger and more popular in the past few years as the Japanese yen has weakened against other currencies. You could get more yen for your dollar, your euro, pound, sterling, or.

More soup dumplings. That's right, And just like the soup dumplings, people were saying that the yen were undervalued a great deal for investors, so they began to borrow even more yin and use that money to fund all kinds of trades. According to Shuley, Now some economists say that carry trade is a strategy that really shouldn't work. What do they mean by that?

Economists like to look at things in the long term, and that basically they will say the value of a currency should reflect it's a purchasing power at home and the interest rate that it earns. So in the purchasing power parody situation, it doesn't matter whether you hold the Japanese yen or the US dollar, you will be able to get the same amount of goods.

But as we've demonstrated clearly, there isn't parody, and that's why you can get more soup dumplings in Tokyo compared to New York. And it's also why the Japanese yen has been a popular currency for carry trades. But it's far from the only currency that can be used to make a carry trade.

It can be anything. Any currencies that have lower interest rates can be used as a funding currency. For instance, like I say, perhaps a decade ago, the US dollar was not yielding any interest rates right, and there was a very popular funding currency for traders to buy into emergent market currencies such as the Indonesian rubia, the Turkish lera, and the Mexican petzil.

And it's really hard to know how much money is parked in carry trades because they're conducted via currency transactions that aren't easy to track. Not to mention there's no one central authority keeping tabs.

This lack of transparency was one contributing factor to the market turmoil this summer, because no one knew just how much money was in yen carry trades and how many positions would need to be unwound.

And if we know one thing about markets, David, it's that they hate uncertainty. After the break, we'll look at whether this summer's meltdown has stopped the rising popularity of carry trades or if they'll carry on nice sorry coundry resist.

Basically, as long as Japan kept its interest rate near zero, and again this is the key point. As long as the en was undervalued, these en carry trades were reliable, little profit machines.

What possibly could go wrong?

Coming into the meeting, we actually had economists surveyed by Bloomber thinking that the consensus would be no change in the interest rate policy. But then this morning we woke up to news that they were discussing a rate high.

Surprise, surprise, the Bank of Japan raised the interest rate by twenty five basis points and that called a lot of people by surprise.

Oh my goodness, it's a awful time.

I think to be at the Bank of Japan right now, because they are in the between a rock and a hard place.

I mean they have been now.

To be clear, an interest rate of zero point two five percent is very low compared to most countries. But that's not the only thing that happened. The yen strengthened against a basket of currencies at nearly its fastest pace in two decades. So a combination of the Fed cutting rates, with the Bank of Japan raising rates, and a strengthening.

Yen led to panic selling, and the brokers started to give our margin cause and a lot of the hatch fans had no choice but to unwind their trades.

Hedge from sold stocks in Japan at the fastest pace in more than five years. It is looking ugly out there. Age inequities have been selling off aggressively.

This carry trade, which seemed like the easy trade, is no longer, so you start exiting fast and it starts to be self fulfilling.

On wines and on wines and on wines.

Billions of dollars worth of carry trades went up in smoke. So here's what happened, David. Remember that thousand dollars loan I took out from you.

Yes, I'm running the Japanese bank. I lent you one thousand dollars worth of yen at basically no interest rate.

Right, and then I turned around and loaned that one thousand dollars out in the US at an interest rate of five and a half percent.

I remember, now you made sixty bucks. I think that's right.

But now when I borrow money from you, I won't pay an interest rate of zero. I'll have to pay you zero point two five percent on that loan.

Well, point twenty five percent is still a lot lower than five and a half percent, So you would make less money. But it does seem like you'd still make money. Right.

Well, you would be right about that, except that something else happened. When Japan raised interest rates. The value of the yen went up by a lot.

So when you convert your US dollars back to yen to pay me back for that loan I gave you, your US dollars aren't worth as much. A thousand US dollars doesn't buy as much yen as it used.

To, exactly, so when I paid back that one thousand dollars loan, I might have to pay more like eleven hundred dollars now, So.

Between a higher interest rate from me and your dollars buying fewer yen, that's sixty bucks you made in profit on your carry trade is basically gone vanished.

If I'm lucky, I might actually now have lost money on this carry trade. Shuley Wren said, it's like that famous Warren Buffett quote about what happens to people who haven't prepared for market change.

So basically, it's like a tide coming to the beach and then stop, and then that tie suddenly receded, and then we got to see who was swimming naked. Basically, we actually see that the yen's movement was highly colerated with the movement of NESTAC, so Japan's currency is affecting US stall market.

For a long time, carry trades were mostly done via bonds and other currencies like the yen peso carry trade, But over the past few years, traders have been borrowing yen to buy American tech companies, juicing their returns, which was why the decision to unwind those trades sparked a selloff on the Nasdaq a few weeks ago.

Now there must have been a lot of upset investors when the Bank of Japan raised rates and the markets crashed. Was there a lot of criticism of what the Bank of Japan was doing.

Yes, there was a lot of criticism saying that the Bank of Japan was bearing it it's head in the sand, that it was raising interest rates too early.

But I have to.

Say that you know, this one sided bet on the yen has been going on so long.

So it sounds like you think it was bound to happen this correction.

Yes, it was already getting too big.

So now that the correction has happened, where does all of this leave the yen? Carry trade?

The carria trade will only get very popular if people can see it's a one way back and that that's probably not what the Bank of Japan wants the yen to behave, right, And then that's a problem that the other central banks have seen as well, because if the carry trade is too popular and the central bank suddenly changes its interest rate regime, we will see this kind of violent wine that we saw in August.

So there you go, David.

The carry trade, the carry trade, the en carry trade in particular, was going strong on the idea that interest rates in Japan would remain relatively low even as central banks in the US and the UK cut rates, and that would continue to make the en week relative to other currencies, so borrowing money would essentially be much cheaper there.

In other words, people would be able to pay for five dumplings and get eight.

Speaking of dumplings, Wind, any chance you could FedEx me some of those dumplings. It doesn't look like I'll get a reservation here in New York at any times.

Sued that will cost you a little more than ten dollars. David, Okay, I'm going to go dig into one of these Shollong bows before they get cold my permission.

I'm so jealous right now.

This is the Big take Asia from Bloomberg News.

I'm wanh and I'm David Gerre. For more on the Carrie trade blow up, you can listen to our sister podcast, Odd Lots. Tracy Alloway and Joe Wisenthal recently spoke with Jon Song Shin of the Bank of International Settlements. That's the bank of Banks that's been trying to track down just how big the Yen Carrie trade is. You can find that wherever you get your Podcasts.

This episode was produced by Young Young Name me Um, Jessica Beck and Alex Huguiera, who also mixed it.

And Kim Gidtleson, who also edited this episode, along with Stacy Vanick Smith, Nicholas Reynolds, and Caitlin Kenney. It was fact checked by Eddie Dwan.

Our senior editor is Elizabeth Ponso, Nicole Beemster Bower is our executive producer, and Sage Bouman is Bloomberg's head of podcasts. If you like our show, please leave us a review wherever you listen to podcasts, or tell your friends it makes a big difference. Thank you and see you next time.