The yen carry trade is unwinding, raising U.S. recession risks

Kiyoshi Ota/Bloomberg

Déjà vu is the feeling of having been somewhere before. Higher interest rates in the U.S. tend to depreciate the yen and encourage yen-funded activities known as the carry trade. On July 30, the Bank of Japan, or BOJ, unexpectedly increased its policy rate from 10 bps to 25 bps and also announced a plan for quantitative tightening, or QT, which began August 1. The last several days have been a reminder that the yen carry trade is highly procyclical. Basically, a feedback loop of yen appreciation can occur as the unwinding of yen funding creates demand for the yen. Also, liquidations are associated with the sale of risk assets funded through the carry trade, causing the price of risk assets to fall. So, once again, the global economy has found itself in another unwinding of the yen carry trade.

Significant unwinding in the yen carry trade has happened before. In their 2009 paper reflecting on the role of the yen carry trade in the 2008 crisis, Masazumi Hattori and Hyun S. Shin note that "yen carry trades have traditionally been viewed in narrow terms purely as a foreign exchange transaction. … [T]he carry trade should instead be viewed in the broader context of global credit conditions. We show that the volume of yen funding that is channeled for use outside of Japan is mirrored by fluctuations in the size of U.S. broker dealer balance sheets. The conjunction of deteriorating credit conditions in the United States and the weakness of the dollar against the yen can be seen as two sides of the same coin. Both are consequences of [U.S.] financial sector deleveraging. ..."

This is why U.S. banks need to pay attention to these developments. The tightening of Japanese banks' balance sheets, risk of credit conditions significantly tightening and a negative confidence/wealth shock increase U.S. recession risk. Bank of International Settlements, or BIS, data indicates that in Q1 2006 there was the equivalent of $1.08 trillion in yen denominated claims, or credit extensions, globally. The BIS data shows in Q1 that global yen-denominated claims have roughly doubled to $2.2 trillion, due mostly to growth in nonbank financial firms' yen borrowing.

More broadly, in Q1 2006 Japanese banks had foreign claims (on a guarantor basis) totaling $1.5 trillion, the sixth highest in the world. As of Q1 2024, BIS data shows  Japanese banks had $5.1 trillion in claims on foreign entities, the number one spot globally for most foreign lending. Per the BIS data as of Q1 2024, the U.S. and Cayman Islands (where an interesting list of U.S. and foreign banks are active) are the top two destinations for Japanese bank credit at $2.2 trillion and $0.78 trillion, respectively. So, yen carry trade aside, Japanese banks' credit provision abroad is no small matter.

OK, but financial markets are showing some signs of stabilizing, the yen has appreciated back to early 2024 levels and the BOJ has tightened by 15 basis points. It is hard to know what course the BOJ may chart from here, but this could be an overly simplistic view. There are many players in the yen carry trade. Hedge funds and other short-term accounts likely would be the first to be flushed out. However, the yen carry trade also has fewer mark-to-market-sensitive players, including banks and nonbank financial intermediates. For now, more of these firms' yen carry trades may persist. Bigger picture: Japanese banks' provision of liquidity/credit abroad may shrink and could significantly tighten credit conditions, raising recession risks. Here are four reasons why balance sheets may tighten.

First, as already noted, Japan is the leading source of credit abroad, both including and beyond the carry trade. However, BOJ tightening has begun to call some of that credit back home to support the yen.

Industry News

Texas Capital Bank hops on private credit boom

The Dallas-based bank is the latest bank to announce plans for a direct lending rollout using nonbank capital.

By Catherine Leffert

August 6

Second, over the last several days, Japanese banks in the Tokyo Stock Price Index have seen about $100 billion equivalent, or about 20% of their market cap, erased. That can negatively impact willingness to lend.

Third, elevated volatility across a range of asset classes has reset value-at-risk measures and reduced internal risk budgets for financial institutions.

Finally, while there have been bouts of periodic yen carry trade unwinding over the last several decades, such episodes have never been coupled with the BOJ undertaking QT. While some central bankers have likened QT to watching paint dry, at its core, QT shifts more intermediation of government securities from the central bank back to the financial sector. Thus, QT can constrain private sector credit intermediation.

For these reasons, the implications of BOJ tightening may be expected to play out further. Debating U.S. real economy indicators may be missing the point. Rather, the withdrawal of Japanese banks' balance sheets from credit provision abroad, risk of credit conditions tightening and a negative confidence/wealth shock are increasing U.S. recession risk.

Thus, central banks must be vigilant for signs of a withdrawal in Japanese banks' credit provision having ripple effects on liquidity elsewhere and/or an associated tightening in credit conditions. A quick end to central bank QT coordinated globally could help. Central banks may also find it proves necessary to take other measures to contain a sharp widening in credit spreads. Better data could help, too. Growth in private credit in the U.S. makes it challenging to monitor U.S. credit conditions even as the BIS data show that nonbank financial firms have significantly expanded their use of yen funding.

Some may argue that U.S. banks' leverage ratios could be reduced to increase balance sheet capacity as leverage ratios are the binding constraints for the largest U.S. banks. However, it would be unwise to lower bank capital late in an economic cycle, particularly in light of recent shocks. The bottom line is that the immediate situation in markets has stabilized, but undue tightening in balance sheets and credit conditions are the risk central banks must be monitoring and ready to offset.