Understanding the Yen, the Carry Trade, and the Movement of Global Capital

One of the questions I occasionally hear from traders is pretty straightforward: Why should I care what the Japanese yen is doing if I trade stocks, options, or even corn?

It is a fair question, and the answer is more important than many traders realize. The trade you are in, or the market move you are trying to understand, may have been financed with yen.

You do not have to become an FX trader to benefit from understanding currencies. You do not even have to place an FX trade. But if you trade stocks, options, bonds, gold, corn, cattle, or almost anything else, it helps to understand how money moves between global markets. One of the best places to begin is with the Japanese yen.

The Yen Is a Bond With a Ticker

I have used this phrase with students for years: the yen is a bond with a ticker.

Think about it from the perspective of a global macro investor. If I can borrow money at an extremely low interest rate and invest that money somewhere offering a potentially higher return, I have the foundation for a trade.

For years, Japan's extraordinarily low interest rates made the yen one of the world's most important funding currencies. The basic mechanics were relatively simple. An investor could borrow yen, sell those yen, convert the proceeds into another currency, and use the capital to purchase an asset expected to generate a higher return.

That asset might be stocks. It could be bonds, commodities, or something else entirely. The specific asset is not really the point. What matters is that an investor can potentially finance a position cheaply in yen and put that capital to work somewhere offering a higher expected return.

This is the foundation of what we call the carry trade.

Following the Movement of Risk

The carry trade becomes particularly interesting when we begin thinking about investor appetite for risk.

When investors are confident and willing to take more risk, capital tends to migrate away from lower-yielding, defensive assets and toward markets where investors believe they can earn a better return. In that environment, investors may sell yen and move away from safer bonds while increasing exposure to stocks and other risk-oriented assets.

If the yen is being sold against the U.S. dollar, USD/JPY tends to move higher. EUR/JPY may move higher as well. At the same time, equities and other risk assets may also be advancing.

This is why I describe the yen as a bond with a ticker. The yen and the bond market can provide different windows into the same fundamental question: Are investors seeking safety, or are they willing to take risk?

Understanding that question can give traders valuable context for what is happening beneath the surface of the market.

Now Run the Movie Backward

The relationship becomes even more interesting when investor sentiment changes.

Suppose investors suddenly become nervous. Risk positions begin to get reduced, stocks come under pressure, and capital starts moving toward perceived safety. Now think back to the original carry trade. If an investor borrowed yen and then sold those yen to finance another position, unwinding that trade eventually requires buying the yen back.

As those positions are unwound, the yen can strengthen. USD/JPY may fall. EUR/JPY may fall. At the same time, money may move toward U.S. Treasury bonds, pushing Treasury prices higher while stocks and other risk assets come under pressure.

The carry-trade unwind in August 2024 offered a powerful illustration of how quickly these relationships can matter. The yen strengthened sharply as global equities experienced significant selling pressure, while longer-duration U.S. Treasury prices benefited during portions of the market stress.

The important lesson is not that one market always causes another to move. Markets are far more complicated than that. The lesson is that seemingly unrelated markets can be connected through the movement and financing of global capital.

Four Charts Worth Watching

There is a simple exercise I recommend for traders who want to develop a better understanding of these relationships. Put four charts on your screen: EUR/JPY, USD/JPY, TLT, and the S&P 500.

You do not have to trade any of them. You are simply going to observe them.

When the S&P 500 is moving higher, look at EUR/JPY and USD/JPY. Are they moving higher as well? What is happening with TLT? If equities begin selling off, does the yen begin strengthening? Are Treasury prices beginning to move higher?

What you are really asking is whether these different markets are telling you the same story about the movement of money and investor appetite for risk.

Over time, you will begin to see relationships that are easy to miss when you look at each market in isolation.

Pay Attention When the Story Changes

There is an important distinction here. I am not suggesting that EUR/JPY predicts the S&P 500. It doesn't. Correlations change, sometimes dramatically, and other forces—including inflation, oil prices, economic growth, central-bank policy, and changing interest-rate expectations—can overwhelm these relationships.

What FX provides is another piece of information.

If stocks continue pushing higher while EUR/JPY and USD/JPY begin moving lower, I pay attention. If long-duration Treasury prices begin moving higher at the same time, I pay even more attention.

Does that mean I immediately sell everything? Of course not.

It means something may be changing underneath the market, and that is information worth having.

There is a significant difference between predicting and observing. Traders spend an enormous amount of time trying to predict what markets will do next. Some of the best information, however, comes from simply learning how to observe what markets are already telling us.

For the next 30 trading days, consider putting EUR/JPY, USD/JPY, TLT, and the S&P 500 on your screen every morning. Don't look for an FX trade. Don't try to predict every move.

Just watch.

Markets leave clues.

You do not have to become an FX trader. But if you want to better understand where global money is moving, and what may be changing beneath the markets you already trade, you need to understand what currencies are telling you.