Investing.com -- Selling Japanese government bonds to buy risker assets like stocks or emerging market debt has been popular trade for years, but the yen 'carry trade' could be nearing end, potentially sparking a chain events that could leave big dent in stocks.
The two-decade regime of low interest rates at the BoJ made the yen carry trade red hot: Traders borrowed Japanese government bonds, or JGBs, like the 10-year JGB to short, or sell, at a cost resembling the yield of the bond, which was low, and used the proceeds from the sale in Japanese yen to buy risker assets with higher returns than like stocks, earning a tidy profit, or spread.
Like with most short selling positions, the risk is always an unexpected rise on the short position -- that risk, once benign is becoming to creep up and that could eventually be bad news for risky assets such as stocks.
"The yen carry trade has been used to fund bull markets in virtually every asset over the years," ... and if it is "starting to reverse, it has negative implications for stocks and other risk assets," Kinsale Trading said in its Sevens Report published Friday.
The yen has strengthened more than 5% against the dollar in a month, stoking fears the yen carry trade may be nearing an end. This has mostly been driven by BOJ intervention to prop up the yen, but there are other factors that could likely push the yen higher including expectations for sooner Fed rate cuts.
"If the Fed becomes surprisingly dovish (and even cuts rates in July) that will cause the yen to strengthen vs. the dollar and that could trigger an unwind of the yen carry trade," Kinsale Trading said.
The political winds of change in U.S., meanwhile, could also play a role in the unwinding of the carry trade.
"Given it’s an election year, there’s the possibility that markets become more worried about the fiscal trajectory of the U.S.," stoking safe-haven demand into JGBs and a decline in the dollar potentially also causing "an unwind of the yen carry trade," it added.