(Bloomberg) -- Never miss an episode. Follow The Big Take Asia podcast today.
They caused global markets to seize up – and raised serious questions about just how much money was at stake. No, we’re not talking about Nvidia’s earnings. Or the US jobs report. We’re talking about carry trades – an obscure part of international markets that’s suddenly less obscure.
Listen and follow The Big Take Asia on Apple Podcasts, Spotify or wherever you get your podcasts
Here is a lightly edited transcript of the conversation:
Oanh Ha: Hello from Hong Kong, David Gura!
David Gura: Oanh Ha! 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 Zoom screen, it looks like you’re having dinner in the studio.
Ha: 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.
Gura: This is torture.
Ha: Let me see here. See if you can see this. Can you see it?
Gura: Oh my gosh, look at that, chopsticks in hand and it looks like a dumpling. Is it a dumpling?
Ha: It is, but it’s not just any dumpling David. This is a xiao long bao, a soup dumpling, right. It’s got yummy broth inside. And it’s from a famous Taiwanese restaurant called Din Tai Fung. They’ve got branches in New York and here in Hong Kong. All over the world.
Gura: And, let me get this straight, their soup dumplings are behind what’s rocking the global currency markets?
Ha: They are, in a way. I’ll let Shuli Ren explain, she’s a Bloomberg Opinion columnist who covers Asian markets.
Shuli Ren: Yes. So the xiao long bao index, it's kind of like the Big Mac index, it tests out the purchasing power of the world's biggest cosmopolitan cities. Din Tai Fung was expanding outside of Taiwan and opening restaurants in the biggest, 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 xiao long bao should be the same, and it turns out they can be quite different.
Ha: So David, we would have ordered you some dumplings from the Din Tai Fung in New York.
Gura: Very thoughtful.
Ha: But apparently they don’t do takeout or delivery. And get this, you have to book seats at midnight, a month in advance.
Gura: A month in advance! My gosh, how good are these dumplings?
Ha: They are very delicious. Luckily for us here in Hong Kong, they’re much easier to get a hold of. So I used the equivalent of 10 U.S. dollars to buy Din Tai Fung dumplings and I got around six xiao long baos, 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.
Gura: Only five.
Ha: Only five. But in Tokyo, once you traded your 10 U.S. dollars for Japanese yen, you’d get around eight dumplings.
Gura: OK so 10 U.S. 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 about all the carry trade news.
Ha: That’s right. Carry trades, right? They’re pretty technical inside markets 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.
Gura: Yeah I’ve watched the value of the yen rise quite a bit against the dollar and that hammered a bunch of these trades.
Ha: That’s right not to mention, 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 Oanh Ha.
Gura: And I’m David Gura. And this is the Big Take Asia from Bloomberg News.
Ha: So David, the news has been full of carry trades lately, they’ve been making a lot of headlines.
Gura: Yeah, they’re new to a lot of people, but the trades themselves have a long history.
Ha: Here’s Shuli Ren again, a Bloomberg columnist who covers Asian markets.
Ren: Carry 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 investors in turn exchange it into another currency and invest in countries that have much higher yielding assets.
Ha: I’ve got a really simple example. David, let’s say I borrow 1,000 dollars worth of Japanese yen from a Japanese bank. Let’s say you’re that bank.
Gura: OK, I’ll lend you that 1,000, and I’m going to charge you a little interest for that loan.
Ha: 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 U.S. dollars, and lend out that money at around five and a half percent, which is the rate in the U.S. at the moment.
Gura: Now this sounds like a pretty good deal for you.
Ha: It is! Now when the person I lent money to pays back my loan, I get back that 1,000 dollars plus interest. Let’s say it’s 1,060 dollars.
Gura: Now you pay me back the 1,000 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 60 bucks.
Ha: Right! Not a bad profit, right?
Gura: Not at all. And that, there, is the appeal of the yen carry trade.
Ha: It's got a funny name. Why is it called a carry trade?
Ren: It's an esoteric name. The traders like to use the word carry. Basically, carry means, earning interest rate differentials.
Ha: And you're essentially carrying that until you make a profit.
Ren: Yes, like you're carrying a baby. It’s like a pregnancy carrying a baby.
Ha: A little profit baby, the kind the markets really love. As Shuli said, the carry trade has been around for a long time, but –
Ren: The most famous carry trades are done by the Japanese retail investors, the so-called Mrs. Watanabe.
Ha: The so-called Mrs. Watanabe 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 popularized the current use in the late 1990s. 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.
Ren: So the Mrs. Watanabes, 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 peso, Turkish lira, Indonesian rupiah. These are all the emerging market currencies that they can earn higher interest rate from.
Ha: But it wasn’t just the Mrs. Watanabes who saw opportunity with the weak yen. The yen carry trade, in its various permutations, is now carried out by hedge funds, investment firms and traders all over the world.
Gura: 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, or your euro, or pound sterling.
Ha: Or more soup dumplings!
Gura: Fair enough.
Ha: That’s right. And just like the soup dumplings, people were saying that the yen was undervalued. A great deal for investors! So they began to borrow even more yen and used that money to fund all kinds of trades, according to Shuli.
Ha: Now, some economists say that carry trade is a strategy that really shouldn't work. What do they mean by that?
Ren: Economists like to look at things in the long term. And basically, they will say the value of a currency should reflect its purchasing power at home and the interest rate that it earns. So in the purchasing power parity situation, it doesn't matter whether you hold the Japanese yen or the U.S. dollar, you will be able to get the same amount of goods.
Gura: But as we’ve demonstrated clearly there isn’t parity – 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.
Ren: It can be anything. Any currencies that have lower interest rates can be used as a funding currency. For instance, like say, perhaps a decade ago, the U.S. dollar was not yielding any interest rates, right? And there was a very popular funding currency for traders to buy into emerging market currencies such as the Indonesian rupiah, the Turkish lira and the Mexican peso.
Ha: 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.
Gura: 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.
Ha: 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?
Gura: Nice.
Ha: Sorry, I couldn’t resist!
Ha: So to recap: one of the most popular carry trades of the past few years was the yen carry trade. When investors all over the world were making a ton of money borrowing Japanese yen at an interest rate of almost zero and then lending it out for a profit or investing it.
Gura: Basically as long as Japan kept its interest rates near zero and again – this is the key point – as long as the yen was undervalued, these yen carry trades were reliable, little profit machines.
Ha: What possibly could go wrong?
Shery Ahn: Coming into the meeting we actually had economists surveilled by Bloomberg thinking that the consensus would be no change in the interest rate policy but then this morning we woke up to news they were discussing a rate hike…
Ren: Surprise, surprise, the Bank of Japan raised the interest rate by 25 basis points, and that caught a lot of people by surprise.
Katrina Ell: Oh my goodness, it’s, it’s an awful time, I think, to be at the Bank of Japan right now because they are between a rock and a hard place...
Ha: Now, to be clear, an interest rate of 0.25% 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 –
Ren: Panic selling, and the brokers started to give out margin calls, and a lot of hedge funds had no choice but to unwind their trades.
Anna Edwards: Hedge funds sold stocks in Japan at the fastest pace in more than five years...
Guy Johnson: It is looking ugly out there. Asian equities have been selling off aggressively…
Liz McCormick: This carry trade, which seemed like the easy trade, is no longer. So you start exiting fast and it starts to be self-fulfilling, unwinds, and unwinds and unwinds...
Ha: Billions of dollars worth of carry trades went up in smoke. So here’s what happened. David, remember that 1,000 dollar loan I took out from you?
Gura: Yes, I’m running the Japanese Bank. I lent you 1,000 dollars worth of yen at basically no interest rate.
Ha: Right, and then I turned around and loaned that 1,000 dollars out in the US at an interest rate of five and a half percent.
Gura: I remember now, you made 60 bucks I think.
Ha: 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 0.25% on that loan.
Gura: Well, 0.25% is still a lot lower than five and a half percent. So you’d make less money, but it does seem like you’d still make money, right?
Ha: 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.
Gura: 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.
Ha: Exactly, so when I pay back that 1,000 dollar loan, I might have to pay more like 1,100 dollars now.
Gura: So between a higher interest rate from me and your dollars buying fewer yen, that 60 bucks you made in profit on your carry trade is… basically gone.
Ha: Vanished… if I’m lucky. I might actually now have lost money on this carry trade. Shuli Ren said it’s like that famous Warren Buffet quote about what happens to people who haven’t prepared for a market change.
Ren: So basically, It's like a tide coming to the beach nonstop. And then that tide suddenly receded and we got to see who was swimming naked, basically. We actually see that the Yen’s movement was highly correlated with the movement of Nasdaq. So Japan's currency is affecting U.S. stock market.
Gura: 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 had been borrowing yen to buy American tech companies -- juicing their returns. Which was why the decision to unwind those trades sparked a sell-off on the Nasdaq a few weeks ago.
Ha: 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?
Ren: Yes, there was a lot of criticism saying that the Bank of Japan was burying its 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.
Ha: So it sounds like you think it was bound to happen, this correction.
Ren: Yes. It was already getting too big.
Gura: So now that a correction has happened, where does all of this leave the yen carry trade?
Ren: The carry trade will only get very popular if people can see it's a one way bet. And that's probably not what the Bank of Japan wants the yen to behave, right? And then that's a problem that 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 unwind that we saw in August.
Ha: So there you go, David. The carry trade.
Gura: The carry trade, the yen 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 U.S. and the U.K. cut rates – and that would continue to make the yen weak relative to other currencies. So borrowing money would essentially be much cheaper there.
Ha: In other words, people would be able to pay for five dumplings and get eight.
Gura: Speaking of dumplings, Oanh. Any chance you could Fedex me some of those dumplings? It doesn’t look like I’ll get a reservation here in New York anytime soon.
Ha: That’ll cost you a little more than 10 dollars David. Ok, I’m going to go dig into one of these xiao long baos before they get cold.
Gura: You have my permission. I’m so jealous right now.
©2024 Bloomberg L.P.
