Yen Rate Hike Triggers Reversal of Carry Trade: Dollar, Gold, Bitcoin All Fall

Core Viewpoints

• After the release of important macroeconomic data in July, the US dollar, gold, and Bitcoin rarely fell simultaneously.
• This phenomenon is primarily caused by the additional margin requirements of the yen carry trade, leading to a large number of gold and Bitcoin positions being liquidated to provide dollar liquidity.
• The Bank of Japan's interest rate hike reflects its determination to maintain the yen's exchange rate, which may not have a significant long-term impact on asset prices, but could have profound effects on Japan's macroeconomy, especially in foreign trade and high-end manufacturing.

1. The reversal of yen carry trade leads to temporary liquidity shortage

Historically, it is rare for gold priced in dollars and Bitcoin to fall significantly in sync. Typically, these two assets are negatively correlated with the dollar index, and due to their common anti-inflation characteristics and high liquidity, they exhibit a positive correlation with each other.

In early August 2024, despite U.S. economic data falling short of expectations and the Federal Reserve's rate cut in September being almost a foregone conclusion, the U.S. dollar index plummeted while gold and Bitcoin prices also saw significant declines. This was mainly due to the Bank of Japan's first rate hike after exiting YCC, which led to a reversal of yen carry trades.

The yen carry trade refers to the trading model of borrowing yen at extremely low interest rates, then converting it into dollars to hold dollar assets. In recent years, the interest rate differential between Japan and the U.S. has reached as high as 5%, making this trading model very active.

After the Bank of Japan unexpectedly raised interest rates, Japanese market interest rates, the yen exchange rate, and Japanese bond yields surged simultaneously, significantly narrowing the Japan-U.S. interest rate differential. To avoid being forcibly liquidated, many traders were forced to liquidate their positions in safe-haven assets such as gold and Bitcoin, converting them into dollars to add margin, resulting in immense selling pressure on Bitcoin and gold.

Currently, the long-term interest rate differential between the US and Japan has fallen below 3%, and the USD/JPY exchange rate continues to decline, increasing the cost and difficulty of yen-denominated carry trades. It is expected that the decline in carry trades will continue for about 3-5 months.

2. The impact of carry trade reversal on most asset prices is limited

In addition to causing short-term tightness in US dollar liquidity and fluctuations in safe-haven asset prices, in the long term, the reversal of carry trades has little impact on assets other than the yen and Japanese government bonds, and there are no obvious response patterns or causal relationships.

Since the collapse of the Japanese bubble economy in the 1990s, when the yen became the main carry trade currency, there have been 5 rounds of interest rate reversal phenomena in history. In addition to causing capital to flow back to Japan, the yen exchange rate to rise, and Japanese bond yields to increase, the global stock assets' response to each round of interest rate reversals has not been consistent.

3. The reversal of carry trade may have far-reaching impacts on Japan's macroeconomy

The exchange rate of the yen and the reversal of carry trades present a reinforcing chain of logical transmission. Interest rate hikes by the central bank lead to a narrowing of interest rate differentials and a reversal of carry trades; the reversal of carry trades leads to capital inflow and appreciation of the yen; the expansion of returns on yen-denominated assets further weakens the motivation for carry trades, forming a reinforcing cycle.

The Bank of Japan's interest rate hike aims to maintain the stability of the purchasing power of the yen, but the rise in the yen's exchange rate may harm the Japanese economy. Currently, the policy authorities do not seem to have provided a good solution.

Although Japan's foreign trade does not account for a high percentage of GDP, Japan's exports are mainly composed of industrial products, especially in the automotive industry. The automotive industry has a long supply chain, can provide a large number of jobs, and has high production efficiency. Through the Balassa-Samuelson effect, the high wage levels in manufacturing will transmit to the non-trade sector, driving overall economic development. In addition, the portion of Japanese automotive brands that builds factories overseas for direct sales is not included in GDP, leading to an underestimation of the pillar role of the export-oriented industry in Japan's economy.

Therefore, in the context of continued weak domestic demand in Japan, the significant rise in the yen exchange rate may have adverse effects on the Japanese automotive industry, which is competing with Chinese cars globally, and on the Japanese semiconductor industry, which is trying to regain its former glory. For the past 30 years, Japan has been resisting deflation, and the recent hawkish stance of the Bank of Japan undoubtedly casts a shadow over the short-term outlook for the Japanese economy.