Yen Carry Time Bomb: Unpacking the Bank of Japan’s Rate Hike and the Looming Threat to Global Markets

If you exit Central Park, which is called the lungs and heart of New York, USA, toward the southeastern city center, you will come across the Plaza Hotel at the exit. It is a very historic hotel built in 1907, 117 years ago. It is also famous as the filming location for the Christmas comedy ‘Home Alone 2’, which set the record for the highest box office hit in Hollywood film history.

On September 22, 1985, the finance ministers of five countries were held at the Plaza Hotel in New York. The finance ministers of the five advanced countries, the United States, the United Kingdom, France, Germany, and Japan, so-called the G5, gathered in one place. The G5 is the root of the G7, a meeting of seven advanced countries, and the G20, a meeting of 20 countries. The country that called the G5 meeting at that time was the United States. It was led by Baker, who was the US Treasury Secretary under President Reagan.

At that time, the United States was experiencing great economic difficulties. It was on the verge of national bankruptcy due to the so-called twin deficits of trade deficit and fiscal deficit. The deficit in trade with Japan was particularly serious. Economists even pointed out that the United States was finally collapsing and the era of Japan was dawning. The meeting called to resolve this imbalance was the Plaza Conference.

The finance ministers of the five countries, the United States, the United Kingdom, France, Germany, and Japan, made a secret agreement at that meeting that had never been heard of before, called “coordinated intervention to weaken the dollar.” The five governments agreed to set a target exchange rate and collude to sell U.S. dollars and buy Japanese yen until that rate was reached.

This is the famous Plaza Accord. It is simply called the ‘Plaza Accord’ for short, referring to the agreement reached at the New York Plaza Hotel conference. After the Plaza Accord, the exchange rate actually changed significantly. The US dollar fell significantly in value, and the Japanese yen soared in value. The yen-dollar exchange rate, which had been fluctuating around 260 yen per dollar, fell to 80 yen per dollar in the three months after the Plaza Accord. It was the largest change since mankind introduced the floating exchange rate system. The rapid change in the exchange rate brought about great changes to the world economy. The US exports increased explosively due to the weak dollar. The trade balance improved dramatically.

The Plaza Conference caused great pain to Japan. As the yen exchange rate fell sharply, Japan’s export competitiveness collapsed. The rapid appreciation of the yen eventually shook the foundations of the Japanese economy. It is no exaggeration to say that Japan’s lost 40 years began with the Plaza Conference. The so-called bubble burst, causing housing prices to plummet and stock prices to hit rock bottom. Since then, Japan has struggled to escape the recession. In particular, the Abe administration implemented large-scale economic stimulus measures under the name of the three arrows, including large-scale quantitative easing, negative interest rates, and a weak yen. In the process, the yen carry trade occurred. The core of the yen carry trade is borrowing stones at low interest rates in Japan and investing them in overseas financial markets.

The term “Watanabe Madam” also came into being at this time. “Watanabe Madam” refers to Japanese individual investors who make high profits through yen carry trade. It is derived from “Watanabe”, the most common surname in Japan. Initially, it was a term referring to a Japanese housewife investment group, but it is now being used in a broader sense.

As the world went through the Corona pandemic, there was a big change in the yen carry trade. Almost all countries on the global stage, including the US and Europe, raised interest rates for a while, saying that they were controlling inflation as prices rose due to the money released during Corona. As a result, inflation is decreasing. As concerns about an economic recession were raised due to high interest rates, countries around the world, including the US, are now competitively lowering interest rates. The US Federal Reserve FOMC has also cut its base interest rate for the first time in four years.

Japan is different. They have been releasing too much money for a long time to overcome the lost 40 years of recession, so they are in a situation where they have to raise interest rates instead. As Japan is the only one raising interest rates while the rest of the world is lowering interest rates, the value of the Japanese yen is skyrocketing day after day. The Watanabes, who have been borrowing money at low interest rates in Japan and investing in the global world, are now in a situation where they have to withdraw their overseas investments and return them to Japan. This is the process in which the large-scale liquidation of yen carry funds is occurring. The financial markets are shaking as Japanese money is flowing out of the New York Stock Exchange and European stock markets all at once. The New York Stock Exchange has also experienced several seizures due to the yen carry liquidation. Whenever the US Federal Reserve FOMC lowers interest rates, yen carry liquidation seizures can occur. This is why the global financial markets are paying more attention to yen carry liquidation than Jerome Powell’s big cut interest rate cut. If the U.S. Federal Reserve FOMC carries out a big cut in interest rates, the yen exchange rate could fall even further, resulting in an explosion of yen carry liquidation.

According to the New York Stock Exchange and the foreign exchange market on September 16, the dollar-yen exchange rate finally collapsed below 140 yen. On that day, the dollar-yen exchange rate fell to 139.951 yen. This is the lowest level in 1 year and 2 months since July 28, 2023, when it recorded 138.058 yen. The dollar-yen exchange rate barely recovered the 140 yen level, but if the yen continues to strengthen, it could fall below 140 yen again. The Bank of Japan, the central bank of Japan, will hold a monetary policy meeting for two days on September 19 and 20. It is a meeting as important as the U.S. Federal Reserve’s FOMC. If Japan raises interest rates here again, a storm of yen carry liquidation could occur. The Bank of Japan ended its negative interest rate policy by raising the short-term policy rate, the benchmark interest rate, for the first time in 17 years at the monetary policy meeting in March. In July, it raised the interest rate from 0-0.1% to 0.25%. As concerns about a hard landing for the U.S. economy emerged, the yen strengthened against the dollar in early August and stock prices plunged, showing signs of instability in financial markets.

Accordingly, it is highly likely that the Bank of Japan will refrain from raising interest rates this September. However, since the Bank of Japan has stated that it will continue the trend of raising interest rates, it is highly likely that it will raise interest rates further in the future. In a recent lecture, Naoki Tamura, a member of the Bank of Japan’s Board of Governors, said that if economic and price trends are in line with the Bank of Japan’s outlook, the base interest rate “should be raised to at least 1%.” Members of the Bank of Japan (BOJ), the central bank of Japan, have been making statements one after another suggesting a rate hike. Naoki Tamura, a member of the BOJ Board of Governors, said at an economic and financial roundtable held in Okayama City today that if economic and price trends are in line with the BOJ’s outlook, it would be appropriate to raise the policy interest rate to at least 1%.

Earlier, BOJ Governor Kazuo Ueda stated that if inflation continues as expected until 2026 (April 2026 to March 2027), the policy interest rate will be close to the neutral interest rate level that does not overheat or cool the economy. The neutral interest rate is the theoretical interest rate level that can match the supply and demand of funds in a stable price environment without inflation or deflation. On this day, it can be seen that Deliberation Committee member Tamura presented an estimate that the neutral interest rate will be “at least around 1%.” This is a warning that Japan’s base interest rate, currently at 0.25%, could rise by 1%. If Japan raises its interest rate in the opposite direction, as the U.S. Federal Reserve’s FOMC is certain to continue cutting interest rates, the yen carry seizure phenomenon could become that much more serious.

It is virtually impossible to accurately measure the size of the liquidable yen carry trade. New York Stock Exchange experts estimate it to be in the range of $4 trillion to $5 trillion. Depending on the extent and speed of the reverse interest rate trend in the U.S. and Japan, the yen carry liquidation could have a larger impact.

Daeho Kim, Editor-in-Chief of Global Economics/ Doctor of Economics tiger8280@g-enews.com