Yen Interest Rate Hike and the Reversal of Carry Trade: Analyzing the Simultaneous Decline of the Dollar, Gold, and Bitcoin

Overview of Opinions

• After the macroeconomic cycle ended in July, the dollar, gold, and Bitcoin rarely fell in sync.
• The main reason is that the demand for liquidity surged due to the additional margin requirements from the yen carry trade, leading to a large number of gold and Bitcoin positions being liquidated to provide USD liquidity.
• The Bank of Japan's interest rate hike reflects its determination to defend the yen exchange rate, which has long shown an unclear relationship with asset prices, but may have far-reaching impacts on Japan's macroeconomy, especially in foreign trade and high-end manufacturing.

1. Analysis of the Low Probability Event of the Fall of the US Dollar, Gold, and Bitcoin in July

Generally, it is rare for gold and Bitcoin priced in US dollars to fall sharply in sync. These two assets typically have a negative correlation with the US dollar index, and due to their common anti-inflation characteristics and high liquidity, prices often show a positive correlation.

In early August 2024, despite U.S. economic data falling short of expectations and the Federal Reserve's interest rate cut in September being almost a foregone conclusion, the dollar index, gold, and Bitcoin prices all experienced significant declines simultaneously. This phenomenon is mainly attributable to the Bank of Japan's first interest rate hike after announcing its exit from yield curve control (YCC) at the end of July, leading to a reversal of yen carry trades.

Yen carry trading is a trading model that borrows yen at extremely low interest rates and then exchanges it for dollars to hold dollar assets. In recent years, this trading model has become increasingly active due to the long-term maintenance of the Japan-U.S. interest rate differential at over 3%.

After the Bank of Japan unexpectedly raised interest rates, Japanese market interest rates, the yen exchange rate, and Japanese bond yields all rose simultaneously, leading to a rapid narrowing of the Japan-US interest rate differential. To avoid being forcibly liquidated, many investors had to liquidate their positions in safe-haven assets such as gold and Bitcoin, converting them into US dollars for additional margin, resulting in significant 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 the yen exchange carry trade. The retreat of carry trades is expected to last for another 3-5 months.

2. The long-term impact of interest rate arbitrage reversal on asset prices is limited.

In addition to causing short-term liquidity shortages in the US dollar and price fluctuations in safe-haven assets, the reversal of carry trades has limited impact on assets other than the yen and Japanese bonds in the long term. Since the yen became a major carry trade currency in the 1990s, there have been five historical instances of carry trade reversals. Apart from leading to a capital inflow into Japan, accelerating the rise of the yen exchange rate and increasing Japanese bond yields, the global stock assets' response to each round of carry reversals has not been consistent.

The fluctuations of these five rounds of interest rate trap transactions occurred in 1998, 2002, 2007, 2015, and 2022. Among them, the global stock market performed well in 1998 and 2022, while the other three times performed poorly, making it difficult to summarize reliable patterns.

3. The Potential Impact of the Yen Interest Rate Hike on Japan's Macroeconomy

The exchange rate of the Japanese yen and the reversal of carry trade present a logic transmission chain of cyclical strengthening. Interest rate hikes by the central bank lead to a narrowing of interest rate differentials and a reversal of carry trades, which in turn triggers capital inflows and an appreciation of the yen. The returns on yen-denominated assets expand, further weakening 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 its currency, but in the face of the potential negative impact of the yen's appreciation on the Japanese economy, policymakers seem to have yet to provide a clear solution.

Although Japan's foreign trade does not account for a high proportion of GDP, its exports are mainly industrial products, particularly centered around the automobile industry. The automobile industry has a long supply chain, can provide a large number of job opportunities, and has high production efficiency. Due to the Balassa-Samuelson effect, the high wage levels in the manufacturing trade sector quickly transmit to the non-trade sector, driving the overall development of the Japanese economy. In addition, the portion of large Japanese automobile brands that builds factories overseas for direct sales is not included in GDP, leading to an underestimation of the supporting role of the outward-oriented export industry in the Japanese economy.

In the context of persistently weak domestic demand in Japan, the significant rise in the yen exchange rate may bring adverse effects to the Japanese automotive industry, which is competing globally, and the semiconductor industry, which is attempting to revive. For the past 30 years, Japan has been striving to resist deflation, and this time the Bank of Japan has shown a clear hawkish stance, undoubtedly casting a shadow over the short-term prospects of the Japanese economy.