In today’s Finshots, we look at how Japan’s rate hikes could disrupt yen carry trades and impact global and Indian markets.

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The Story

Let’s start with a story. Imagine there are three people. Two of them are really wealthy. One has tons of money that he lends out at very low interest rates. The other has assets that make him even richer because they bring in great returns. Then there’s a smart investor. He sees a golden opportunity. He borrows money from the first wealthy person at a cheap rate and invests it with the second wealthy person to earn more. The difference between what he pays as interest and what he earns is his profit.

Now picture this happening on a global scale. The first wealthy person is like Japan, offering loans in yen with very low interest rates. The smart investor is anyone who borrows yen, converts it to dollars or other currencies, and invests in assets that pay much higher returns. This is called the "carry trade" and it’s a way to make money by borrowing cheaply in one place and earning more somewhere else.

So, how does this tie into today’s story? 

Well, Japan has been famous for its negative to ultra-low interest rates for decades. Their central bank, the Bank of Japan (BoJ), followed policies which included things like printing money and keeping borrowing costs almost zero. And this made yen carry trades a popular and profitable strategy for countries as well as investors.

But things started changing last year.

You see, carry trades work best when the yen is weaker than the US dollar. That’s because borrowing yen is cheap, and investing in US assets that give higher returns is easy money. But when the yen gets stronger, this trade starts to fall apart. Because if you’ve borrowed yen, you’ll eventually have to repay that loan in yen. And stronger yen means you’ll need more dollars to pay back the same amount of yen. This can shrink your profits or even turn them into losses.

This brings us to Japan’s recent moves. The BoJ is signaling that it’s done with super-low rates. Last year, in March 2024, it raised their interest rates for the first time in years, from minus 0.1% to 0.1%. Japan did this because inflation was back. After years of falling or stagnant prices, global supply chain problems and higher energy costs started pushing prices up in Japan. And to stop inflation from getting worse, the government decided it was time to tighten the screws by raising rates.

And it did surprise a lot of traders since it was the first rate hike since 2007! 

Not only that but the BoJ also went for a second rate hike in July 2024 to 0.25%.

Presumably, just weeks after the hike, the yen’s value jumped, forcing traders to quickly exit their carry trade positions. This sudden move caused chaos in global markets, with falling stock and bond prices showing how fragile the system can be.

For carry traders, this was a big deal. 

They’ve been enjoying low costs and a stable yen for years - all easy money! But as Japan raised rates, borrowing in yen became more expensive. And now, many think that the BoJ’s next monetary policy meeting this month could bring another rate hike, which might trigger more trouble for carry trades.

But Japan isn’t the only player here. The US also shapes how these trades work.

In the US, the Federal Reserve spent much of last year cutting interest rates. By the end of 2024, they had lowered their target rate to a range of 4.25%-4.50% and hinted at more cuts in 2025.

How does this affect yen carry trades, you ask?

Lower US interest rates make borrowing in dollars less attractive compared to yen. So, yen carry traders see a changing opportunity: the margin between borrowing yen and earning in dollars narrows as US rates decline. If the Federal Reserve goes for another rate cut, the appeal of investing in US dollar-denominated assets is lesser. Traders may begin to question whether the effort of borrowing yen and dealing with potential currency risk is worth the shrinking returns.

Global markets are often worried about carry trades because of how quickly they can unravel. When traders rush to pay back their yen loans, demand for 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.

And this kind of chaos has happened before.

Back in 2007, during the “quant meltdown,” yen carry trades collapsed, and markets went haywire. Hedge funds sold off assets in a panic, the yen surged, and the shockwaves hit stocks and bonds globally. Even last August, something similar happened when the BoJ raised rates, showing how sensitive the world still is to these trades.

This brings us to India — a favourite destination for foreign investors leveraging yen carry trades. A strengthening yen could trigger an unwinding of these trades, leading to capital outflows from India as investors scramble to repay their yen loans. And this could put pressure on the rupee and hurt Indian stocks, especially in sectors that rely on foreign capital.

That said, if we take this analysis further and look closer, the direct impact on India might not be that huge. 

You see, Indian assets under the custody of Japanese foreign portfolio investors (FPIs) stood at ₹2.28 lakh crore as of December 2024. While that might sound like a substantial figure, it’s actually just a small piece of the larger pie since it's roughly 3% of the total ₹77 lakh crores held by the top 10 FPI investors in India.

India’s financial system has come a long way. Over the years, the Reserve Bank of India (RBI) has tightened its regulations, and with forex reserves now topping $640 billion (about ₹54,800 billion), India has a pretty solid cushion against external shocks.

On top of that, the reliance on foreign funds has been shrinking. Foreign inflows into Indian markets have slowed down, while domestic institutional investors are stepping up their game. This shift has made the financial system sturdier and less vulnerable to sudden outflows.

And here’s another bright spot — India’s growing share in global stock market capitalisation. It’s a sign of strength that could help balance out some of the worries.

That said, it’s not all smooth sailing. Sectors as well as investment houses that have more exposure to yen-denominated funds could feel the pinch if the yen strengthens significantly. Repayments could get pricier, and outflows might follow.

But here’s the twist. A stronger yen might actually give Indian exporters a leg up. If Japanese goods become costlier, Indian companies could swoop in and grab a bigger share of the market. Take textile makers, for example. They might outshine their Japanese counterparts if costs in Japan climb.

So yeah, that's the long and short of it.

It all tells us that the yen carry trade is like a game of musical chairs. As long as the music plays — with low Japanese rates and a weak yen — everyone makes money. But when the music stops, chaos breaks out. And Japan’s rate hikes could be like turning down the music, and traders will then eye the chairs nervously.

In conclusion, Japan’s decision to raise rates is a turning point. It could shake up the carry trade world and create ripples in global as well as Indian markets. And maybe, for carry traders, the days of easy profits may come to a halt. At least for a while if not for the long term, replaced by a more unpredictable and risky environment.

Nonetheless, this tells how deeply interconnected the global financial system really is.

Until then…

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