For months now, market watchers have been buzzing about a popular trading strategy: borrowing yen at ultra-low rates and investing those funds in high-growth assets, like the "Mag 7".
This strategy, known as "arbitrage trading," relies on borrowing cheaply and investing in high returns. This is a common strategy because carry trades can be very lucrative if they succeed.
But when such a popular arbitrage strategy suddenly goes awry, the fallout can be significant.
Concerns have been rising about this type of trading, partly because of the massive amounts of money involved—estimated at around $4 trillion.
On July 31, the Bank of Japan raised its rate from 0.1% to 0.25%. Although this rate hike is still low, it’s the largest increase since 2007, and forex traders couldn’t ignore it.
A seemingly small rate hike has had a huge impact on exchange rates. The yen quickly responded, appreciating from about 162 yen per dollar in early July to around 150 yen, and even further to about 143 yen by Monday.
If you borrowed yen and converted it to dollars or euros, you now need to earn more to repay the yen-denominated loan due to the yen’s appreciation.
For example, if you borrowed 10 million yen a month ago and converted it to around $62,000, you now need about $70,000 to repay the loan, not including interest and fees. In other words, even with just a 0.15% rate hike, your investment returns would need to be about 13% just to cover the yen loan.
Why are investors rushing to unwind arbitrage trades now?
The Bank of Japan has hinted at more rate hikes in the future, suggesting further yen appreciation against the dollar. This is pushing investors to unwind their trades quickly to repay their yen loans. Given the huge amount of money involved, investors are selling stocks or other assets to pay off these loans, causing a significant market impact.
Additionally, fears of a U.S. economic downturn are adding to the market decline, as recent indicators show slowing economic growth. These two factors together are creating a downward spiral, leading to more selloff. Even investors not involved in arbitrage might panic seeing stocks of major companies like NVIDIA and Tesla plummet.
However, some stocks with high growth potential might rebound in the short term due to bargain hunting. Just keep in mind that the selloff could continue, given the massive $4 trillion involved.
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