Japan's central bank's decision to increase rates undermined the carry trade strategy. Know what is carry strategy is and how it affects the Indian stock market on August 5
As benchmark indices Sensex and Nifty experienced significant selling throughout the day, let's see how a decision by the Bank of Japan played a major part in the market's direction. Today the BSE’s 30-share Sensex dropped by nearly 2.73 percent to 78,773 by 3.30 pm. There are several reasons behind the route from geo-political impact, to unemployment data from the US etc. But a major factor has been the rate hikes by the Bank of Japan.
After the Bank of Japan increased rates on July 31, 2024, Japan’s currency, the yen, appreciated, negatively affecting a popular strategy used by investors called ‘carry trade’. This created a ripple effect, leading to sell-off in Indian markets.
On July 31, 2024, the Bank of Japan raised its short-term policy rate from -0.1 per cent to between 0 per cent and 0.1 per cent, which made yen 8 per cent expensive over the past month. It surged the dollar, further affecting the yen-funded carry trades.
Carry trade is a strategy in which investors borrow money in a currency with low interest rates and invest it in higher-yielding assets.
When yen appreciated, carry trade became untenable, leading to a sell-off in Japanese and US stocks. This massive sell-off acted as an additional red flag for investors who were spooked about a slowdown in the US economy, triggering a sell-off in the Indian markets, too.
The Indian stock market is usually impacted by sell-offs in US markets with a spillover effect. A bearish trend in the US can lead to panic, increased volatility, and selling pressure. Also, after an indication of a slowdown in the US economy, demand for Indian exports in select sectors, such as the IT sector can go down, which investors may have factored in.
Hemant Mishra, co-founder and CIO of Singapore-based fund management company S CUBE Capital, said: “Investors utilise low Japanese interest rates to fund investments in higher-yielding assets globally. The yen has been a favourite for carrying trade currency for 40 years on account of its low interest rates and weakening bias. This trend has intensified ever since the US Federal Reserve started increasing interest rates. It is now estimated at $2.5 trillion, an increase of more than 55 per cent since the end of 2021.”
“The sharp move in yen has triggered liquidations by global macro and hedge fund players who have borrowed in the yen. The double whammy of Bank of Japan actions (long anticipated) and concerns of the US tipping into an economic downturn or recession (which we think are misplaced) has led to unwinding of risk assets,” he added.
He said the geopolitical situation in the Middle East (referring to the possibility of an Israel-Iran conflict) could worsen the situation.
“The geopolitics surrounding the Middle East and recent escalations may add further fuel. There is a risk of this impacting all risk assets, including emerging markets, unless the central banks step in to stem the rout. Indian markets, while fundamentally strong, will not be insulated as investors will be looking to book profits to fund their global losses.”