Imagine that you could borrow money at an extremely low rate of interest, or even interest-free.
You could then take that money and invest it in a certificate of deposit, bond, or other fixed income instrument, and collect interest.
Your profit would be the difference between the interest you collect, and the interest you must pay on borrowed funds.
A similar situation exists in the currency markets. Japan’s benchmark interest rate was actually zero percent for several years up until 2006. During that same time, the U.S. raised its benchmark interest rate from 1.0% up to 5.25%.
Forex traders could borrow money from Japan at almost zero percent, and invest it in the U.S. at 5.25%.
Because of this, institutional traders piled into long positions in the USD/JPY currency pair to take advantage of this difference in interest rates.
The trouble is, this interest rate differential is now beginning to shrink.
The U.S. ended its campaign of rate hikes last year, and Japan began to raise rates. Now, instead of borrowing at zero percent, traders must pay 0.5% for money borrowed from Japan.
The interest rate differential between the U.S. and Japan is now just 4.75% (5.25% – 0.5%) and will shrink even more if Japan raises rates again, or if the U.S. cuts interest rates.
This makes the Carry Trade less attractive, and as a result, traders have rushed for the exit on USD/JPY.
Similar damage has been done to EUR/JPY and GBP/JPY, as the once weak Yen has come roaring back, reaching three-month highs against the Euro and U.S. Dollar.