A carry crash also kicked off the global financial crisis 17 years ago — here’s why it’s unlikely to get as bad this time
- Written by Charles Read, Fellow in Economics and History at Corpus Christi College, University of Cambridge
Many casual readers of the financial press will have learned a new term in the past few days: the “carry trade”. This is the culprit for the rollercoaster state of markets, many market commentators and journalists have opined[1].
Indeed it also played a role[2] in kicking off the credit crunch and resulting global financial crisis in 2007-08. Should we fear a repeat? The answer this time is both yes and no.
The current rumpus started on Friday August 2 when markets in America dropped in response to worse-than-expected data[3] on the number of new jobs created in July. Then Japanese stocks[4] took a bigger battering on Monday, posting the biggest ever one-day drop in the Nikkei, the country’s main share index. Since then, markets have gyrated up and down as traders and investors attempt to understand what is going on.
So why has the carry trade got the blame? First, a quick explanation of how it works. The carry trade is a financial strategy used by professional investors and also amateurs in the currency market to make money from differences between interest rates in different countries. Investors borrow money in a currency with a low interest-rate and invest it in a currency with a higher interest rate to make a profit.
Investors had been going to town with this strategy in recent years, borrowing cheaply in Japan in yen, where interest rates are still low (0.25%), and investing in place where rates are higher, such as the United States (5.25%-5.5%) and Mexico (10.75%). Researchers at Swiss bank UBS estimate that[5] since 2011, more than US$500 billion (£392 billion) in US dollar-yen carry trades have taken place.
Nikkei average, 2023-24
The run on Northern Rock bank in September 2007 was the first sign of the global financial crisis on the high street.
Stu/Alamy[10]
But while we should be worried about the carry trade, a softer landing is likelier than 2007-08. The narrowing of the difference in interest rates between Japan and America has been slight in recent days. The previous gap of more than 5% has only narrowed by 0.15%. It is only when interest rates between countries converge more closely that you should really panic.
In any case, in retrospect, the current market meltdown looks like it was triggered more by the poor American jobs data than Japan’s decision to slightly raise official interest rates. And those jobs numbers showed a mixed picture[11] rather than being unremittingly terrible. It is far from certain that the US is heading into recession, implying that investors may have sold down stocks more than is warranted.
The events of the past week should be seen as yet another one of the market blowups that have occurred as a result of interest rates across the world rising rapidly in 2022 and 2023, a source of financial fragility. These include the panic triggered by Liz Truss’s mini-budget[12] in Britain in September 2022 and the failure of Silicon Valley Bank[13] in America in March 2023.
More ructions are likely, though hopefully none the size of the 2008 financial crisis. If you’re involved in financial markets, either as investor or investee, the wild ride is not over yet.
References^ have opined (www.ft.com)^ played a role (www.elibrary.imf.org)^ worse-than-expected data (www.theguardian.com)^ Japanese stocks (edition.cnn.com)^ estimate that (www.swissinfo.ch)^ Trading View (www.tradingview.com)^ latest book (link.springer.com)^ a paper (www.bis.org)^ credit crunch (www.investopedia.com)^ Stu/Alamy (www.alamy.com)^ mixed picture (www.reuters.com)^ Liz Truss’s mini-budget (theconversation.com)^ Silicon Valley Bank (theconversation.com)
