what it is
The mechanics are simple: borrow Japanese treasury bonds, sell them and use the proceeds to buy US Treasuries.
You end up being:
–short the yen, a perennially weak currency
–short the (tiny) interest payments on the Japanese bonds
–long the dollar
–long the (larger) interest payments on the Treasuries.
Since the early 1990s, this has been a great place to be.
You profit through two positive spreads:
–the interest income difference between the high yield on Treasuries and the much lower yield on JGBs, plus
–the foreign exchange difference between the relatively strong dollar and the super-weak yen.
This situation has been caused by two factors:
—–the peaking of Japanese GDP growth in 1993, due to aging of the domestic population and the government’s unwillingness to accept foreign workers, and
—–trade barriers that protect relatively inefficient domestic firms from foreign competition.
(an aside: sound familiar?)
why it appears to be ending
Trump’s economic plan is based on three ideas:
–having the Federal Reserve lower interest rates
–applying tariffs to imports, collecting money for the Treasury, but making foreign goods more expensive to US buyers, and
–shrinking the domestic workforce by deporting immigrants.
In other words, he’s more or less copying the Japanese playbook that has produced three decades of economic stagnation. This seems to imply that the spreads that made the yen carry trade so lucrative will ultimately disappear, as the US gets poorer. The most benign explanation I can come up with is that the administration experts just don’t know the basics of how the economic world works in this century.
specific consequences aren’t 100% clear, to me.
What is clear, in my view, is that they’re unlikely to be good.
The plain vanilla version of the carry trade is what I’ve described above. But we live in a multi-flavor world, where the yen carry trade doesn’t stand alone. To the extent that the big international banks are involved, selling JGBs would only be one element in a multi-asset investment strategy. If one element becomes riskier, the banks’ primary concern will be to control the enterprise-wide level of risk. That might come down to simply covering yen short positions. But it could just as well involve de-risking elsewhere–say, unwinding risky crypto or euro trades.
It’s likely, also, that there are private equity or hedge funds with limited overall scope, but who have made a good living for years based on yen carry alone. It’s hard to predict how they might act.
Two final things:
–after thirty+ years of economic stagnation, Japan seems to finally be rejecting the samurai mindset that has produced the current misery. I wonder how long it will take us?
–one of the pillars of strength of Japan during this period has been tourism. Big city shopping, gourmet food, ancient shrines…have all attracted foreign visitors in large numbers. In our case, though, I imagine the possibility of being shot by ICE or imprisoned in a warehouse in the middle of nowhere–or in a real prison in El Salvador–will act as a deterrent to potential vacationers.