How big is the scale of yen carry trade: $1 trillion, $3 trillion, or $20 trillion?

Previously, both the yen arbitrage trading and the collapse of US tech stocks occurred simultaneously. Some media articles claimed that investors believed the two trades were related and were concerned that the dismantling of the yen arbitrage trading would disrupt investors' significant investments in US technology and artificial intelligence-related companies. After all, since early July, the 11% rise in the yen exchange rate has been consistent with the 13% largest pullback in the Nasdaq 100 index.

Yen Arbitrage Trading Becoming Unsustainable

The article mentioned that arbitrage trading refers to investors borrowing low-interest rate currencies from countries like Japan and then investing the funds in countries where higher returns can be obtained. In recent years, due to the Bank of Japan's zero interest rate policy, the yen has always been the most popular funding currency, and this strategy has been a regular operation for the Japanese government and financial institutions over the past forty years.

However, when the Bank of Japan raised interest rates last week, this strategy quickly turned sour.

Previously, Deutsche Bank analysts pointed out that the success of arbitrage trading depends on several key factors: a low-interest rate environment, stability of the yen, and high yields on global assets. With inflation rates continuing to rise, the Bank of Japan was forced to raise interest rates, causing significant stress on the government's balance sheet. Deutsche Bank highlighted the risk of this model facing liquidation.

Therefore, the withdrawal of yen arbitrage trading may have a spillover effect on other markets, and the current issue is how large the scale of this arbitrage trading is.

Trading Volume Exceeding Trillions Will Impact US Stocks

Some investors may have borrowed yen and converted it into US dollars to purchase popular tech stocks such as NVIDIA and Microsoft. This year, the correlation between the yen and the Philadelphia Semiconductor Index is higher than its correlation with Japan's own TOPIX index.

Alternatively, it could be that asset management companies have accumulated illiquid assets, such as emerging market bonds, and margin calls from brokers have forced them to sell the most liquid positions in their portfolios. In this scenario, large US tech stocks would be a good choice.

Therefore, if the scale of this arbitrage trading reaches trillions of dollars, the disorderly dismantling will inevitably amplify the downward trend of the US stock market. The selling pressure faced by the Nasdaq index may temporarily ease for a day or two, but it will not completely end.

Unfortunately, as currency trading is not centrally tracked on exchanges like stock trading, the exact scale of this strategy cannot be determined at present, only roughly estimated.

1 Trillion, 3 Trillion, or 20 Trillion US Dollars?

One indicator that can be referenced is the foreign currency loans of Japanese banks. As of March, this amount reached 1 trillion US dollars, a 21% increase from 2021. According to data from the Bank for International Settlements, most of the recent growth in cross-border yen loans has occurred in the so-called interbank market, where banks lend to each other and to other financial companies (such as asset management firms). This is an estimate of foreign institutional investors' interest in yen funding arbitrage trading.

As for Japanese investors, as of the first quarter, their net international investment amounted to 487 trillion yen (3.4 trillion US dollars), a 17% increase from three years ago. Clearly, most of this comes from foreign exchange reserves. Traditional asset management companies' portfolio arbitrage trading is not the largest piece of the pie However, in a broader sense, it can be said that the entire Japanese government is engaged in large-scale arbitrage trading. The government finances itself through the extremely low real interest rates imposed on domestic depositors by the Bank of Japan, while earning higher returns on foreign assets. Therefore, the $1.8 trillion Government Pension Investment Fund (GPIF), with about half of its funds allocated to overseas stocks and bonds, essentially functions as an asset management company for the government to operate this money-making machine. If the Bank of Japan continues to raise interest rates, will the GPIF still stay in the U.S. stock market?

A previous article by Wall Street News pointed out that Deutsche Bank analysts believe that the scale of arbitrage by the Japanese government is even larger. With the total value of the Japanese government's balance sheet at about 500% of GDP or $20 trillion, in simple terms, the Japanese government's balance sheet is a huge arbitrage trade, which is crucial for Japan to maintain its continuously growing nominal debt level.

Ultimately, arbitrage trading is a leveraged game that uses cheap loans for higher-risk project investments. Now, the Bank of Japan is changing the game plan by raising interest rates, leading to a strong flow of funds into a suddenly interest-paying currency, amounting to trillions of dollars. Therefore, the article believes that the impact of a yen interest rate hike on U.S. stocks is significant