THE CARRY TRADE

 Our readers asked for more financial/investment content. You ask/we deliver.* 

To explain a Carry Trade, we need to define terms. 1) Selling short. A stock or bond goes up or down. An experienced investor who thinks the stock/bond is going to go down can sell it without owning it. Really. It's called selling short. If you think XYZ that has a price of 100 is going down, you sell it at 100 and get the hundred bucks. That's a good part. Let's say you're right and the stock falls to 90. You buy it at 90 and the ten dollars is your profit. Sold at 100 & bought at 90. The downside is let's say you're wrong and the stock goes to 110, then you have lost 10 dollars. The risk in this trade is that your potential loss is unlimited as the stock can just keep going up. Selling short is for experienced traders only. We do it very rarely. Global Crossing way back in the 90's. Snap about ten years ago. 

Okay, still with us? 

There's a group of traders controlling a large amount of money- as much as 100 billion dollars. For almost all of 2010-2025, the Bank Of Japan (BOJ- Japan's equivalent of our fed) kept Japan's interest rate very low- around 1%. During that time the rate of a standard US Treasury Bond was between 4-6%. 

SO, the traders SOLD the Japanese bond at 1% and got the cash. They BOUGHT the US Treasury at say 4% and the difference in the price (called arbitrage) was profit. For example. Sell a thousand-dollar Japanese bond at 1% and pay ten dollars a year in 1% interest. Buy a US Treasury bond for the thousand dollars you got from the Japanese bond at 4% and collect 4% interest/ forty dollars a year. A thirty dollar a year profit!  Now do that for 50 billion dollars and you are making some Rumpole type money.  This is called The Carry Trade. 

BUT what happens when the BOJ decides to raise rates? As Scooby Doo would say "ruup ro!"  The sharp traders bopping along making their 3% arbitrage profit while sipping margaritas in Cabo and looking for their next Lambo have a problem. They need to raise cash to unwind the trade. They have to buy back those billions in Japanese bonds they have sold short. So they SELL their US stocks where they have put their profits (it's complicated why they can't sell their US bonds- they can, but the price will be falling, and they don't want to take another loss) so what happens when a few large firms start dumping billions of US equities? The stock market falls. No Santa Claus rally. 😢

This last happened in January of this year, causing the stock market to rapidly fall for no discernable reason after the Yen strengthened in December 2024.  And it may happen again as Japan's new prime minister (their first female PM) takes bold steps to energize the Japanese economy. 

What to do? Not much. What you need to understand is that there is an external force (unwinding the Japanese Carry Trade) causing stocks to fall. Nothing is wrong with the companies whose stock is being sold by the traders who need to close out their positions in Japan. An external and unrelated issue is causing their price to fall. But people who have their money in those stocks get scared and they start selling as well, and the price falls even more. It usually takes about a week for everything to stabilize. 

So what to do(2)? Remember the wise words of the best investor our generation -Warren Buffet. When people are greedy, be fearful. When people are fearful, be greedy. 

Will all of this happen? Maybe. Watch what the BOJ does on interest rates in December. And then watch the market, and if possible, channel your inner Warren Buffet and be greedy.

We may call these our "Financial Thursdays" because "Financial Fridays" is just too obvious. 

*Except when we don't feel like it.