MacroPass™: Brent Johnson On The Yen Carry Trade

Leverage, losses & lessons

This week’s installment of our popular MacroPass™ service for premium members of this Substack comes from money manager Brent Johnson of Santiago Capital, developer of the Dollar Milkshake Theory.

Brent is one of the foremost experts on currency markets. Earlier this fall, the Japanese yen started appreciating dramatically versus other fiat currencies, sending shock waves through markets as the “yen carry trade”, which the financial system had become accustomed to, started to unwind. The ripple effects from this, while stablized for now, are far from over in Brent’s estimation.

Brent has published a 44-page report on this situation, which we’re making available below.

It provides a comprehensive background on how the carry trade came into being, the role it currently plays in world currency & financial markets, and why investors and policymakers alike must understand the dynamics associated with carry trades as the turbulence associated with them can strike out of nowhere, and there is nothing to indicate these risks have been fully removed from the global landscape.

As a reminder, MacroPass™ is a weekly rotating selection of premium analysis from many of the big thinkers interviewed on Thoughtful Money.

To-date that list of contributors includes experts like Lacy Hunt (Hoisington), Stephanie Pomboy (Macro Mavens), Danielle DiMartino Booth (QI Research), Tom McClellan, Michael Howell (Capital Wars), Darius Dale (42 Macro), Doomberg, Ted Oakley (Oxbow Advisors), Kevin Muir (The Macro Tourist), Alf Peccatiello (The Macro Compass), Lance Lambert (ResiClub), Ed Yardini (Yardini Research), David Hay (Haymaker), Melody Wright (M3_Melody), David Stockman (Contra Corner), David Brady (FIPEST Report), John Rubino, Adam Kobeissi (The Kobeissi Letter), Sven Henrich (Northman Trader), Jeff Clark (The Gold Advisor), Charles Hugh Smith, Steven Bavaria (Inside the Income Factory®), Chris Whalen (The Institutional Risk Analyst) and Brent Johnson (Macro Alchemist).

Recent MacroPass™ reports in this series include:

• David Hay's top investment rankings

• Ted Oakley on his latest market outlook

• Steven Bavaria on income investing

• Charles Hugh Smith on returning to a gold-backed currency

• Chris Whalen on the health of the banking industry

• Jeff Clark on the promising outlook for junior mining stocks

• David Stockman on Bitcoin's threat to fiat currency

• Darius Dale on the market's transition from 'Goldilocks' towards Deflation

• The Kobeissi Letter on tech stock weakness & recession fears

• Melody Wright on fast-worsening housing data

If you’re already a premium subscriber to this Substack, just continue below to access Brent Johnson’s carry trade report.

And if you’re not (yet), read its Executive Summary below and consider upgrading to premium and access the full version, as well as all past and future MacroPass™ content.

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Executive Summary

Currency carry trades, while seemingly straightforward, carry significant risks due to their reliance on interest rate differentials between countries. Investors borrow in a low-interest currency, like the yen, to invest in higher-yielding assets.

These trades are often unhedged and leveraged, magnifying potential profits but also exposing investors to substantial risks, especially if interest rates or currency values shift unexpectedly. The biggest risk is the implicit assumption that these differentials will remain stable, which rarely holds true over the long term.

Historically, even fixed currency pegs, such as those attempted by the Swiss National Bank and the Bank of England, have failed due to unsustainable capital flows. Despite the lessons learned from past failures, such as when the U.S. decoupled the dollar from the gold standard in 1971, investors are often lured by the allure of stable, easy returns from carry trades.

However, carry trades can appear benign for years before unraveling catastrophically, leading to sudden and severe market volatility. This was the case in the recent yen carry trade crisis of August 2024.

The BoJ now faces a dilemma: Do they protect the Yen with higher interest rates? Or protect the Japanese government bond market with lower rates.

They cannot do both.

This is because the tools used to protect their currency conflict with the tools used to protect the bond market. And vice versa.

To protect a currency, A central bank will typically raise interest rates to make the currency more attractive to investors, which can help stabilize or increase its value. However, higher interest rates increase borrowing costs, leading to lower bond prices and rising yields, which can destabilize the bond market. This dynamic creates a policy dilemma, particularly in economies heavily reliant on debt, as higher yields can hurt economic growth and raise concerns about government debt sustainability.

On the other hand, protecting the bond market requires central banks to keep interest rates low, which supports bond prices and keeps borrowing costs manageable for governments and businesses.

However, lower interest rates tend to weaken a currency by making it less attractive to investors seeking higher returns. A weaker currency can fuel inflation by increasing the cost of imports, particularly in energy-dependent economies. Central banks are thus caught in a balancing act, where prioritizing one market often exacerbates risks in the other, making it difficult to maintain stability across both simultaneously.