Why Carry Trades Make the Yen and Franc Swing Sharply

Imagine borrowing a currency that costs almost nothing, converting it into one that pays a higher return, and pocketing the difference. That, in plain terms, is a carry trade. It has been a popular strategy among professional investors for years, and it helps explain why the Japanese yen and the Swiss franc sometimes lurch sharply when the financial world gets nervous.

Carry trades love a quiet world. They need calm exchange rates and predictable interest rates. The minute those assumptions wobble, the trade can reverse quickly. Since many investors are doing similar things at the same time, currency moves can end up sharper than a single worried trader could cause on their own.

The simple wager behind a carry trade

A carry trade starts with two currencies. One, the funding currency, has a low interest rate. The other, the target currency, pays more. An investor borrows the funding currency and uses it to buy assets or deposits in the target currency. The profit comes from the difference in interest rates, as long as the exchange rate does not move enough to erase it.

For a long time, the Japanese yen was a funding currency of choice because borrowing it was so cheap. The Swiss franc also fitted the role, thanks to low and sometimes even negative interest rates. Neither currency needs to be flashy. They work behind the scenes, like the quiet friend who lends you an umbrella and then, one day, wants it back at the exact moment you are standing in the rain.

Leverage makes the wager bigger. Professional investors often borrow more than their own money, which amplifies gains. It also amplifies losses. If the funding currency appreciates suddenly, a leveraged position can turn a tidy interest profit into a painful loss in short order.

Interest rate expectations change the math

Carry trades are only as safe as the expected interest-rate gap. If investors begin to think the low-rate currency will become more expensive to borrow, the strategy quickly loses its appeal. That is exactly what happened in August 2024, when policy meetings at the US Federal Reserve and the Bank of Japan were seen as hawkish, or less inclined to keep rates low. Around the same time, a disappointing US jobs report made investors worry more about growth. Markets reacted strongly: the yen appreciated, Japanese equities fell sharply, and volatility measures around the world spiked, including the VIX, a widely watched gauge of expected stock-market swings.

The Bank for International Settlements, a hub for central banks, later noted that the US data alone did not clearly point to a global recession. The reaction looked amplified by leveraged positions and by traders unwinding bets that had worked while markets were calm. When many people try to reverse the same trade at once, normally orderly currencies can move fast.

Interest rate expectations matter in another way too. A central bank does not have to change rates to move markets. Its words can be enough. After the August turbulence, the Bank of Japan adjusted its communication to sound more cautious about future rate hikes, and investors quickly revised their expectations. Central bank communication, not just rate decisions, is part of the machinery.

A short, sharp lesson from the Swiss franc

Currency moves can be even more dramatic when a central bank changes the rules. In January 2015, the Swiss National Bank had been holding a minimum exchange rate of 1.20 francs per euro to keep Swiss exports competitive. Maintaining that cap meant selling francs and buying foreign currencies, sometimes on a massive scale. Then the central bank abandoned the cap without advance warning.

The market response was immediate. The euro plunged from 1.20 francs to about 0.80 francs in chaotic trading before settling near 1.04. Swiss shares fell sharply, and individual companies felt the sting; the watchmaker Swatch, for one, saw its share price drop by around 15 per cent. Some economists, studying the strong franc and negative interest rates, even asked whether Switzerland might resemble Japan in its stagnant period.

The episode is not a moral tale about currencies being wrong. It is a reminder that when a central bank has been leaning against a move, the eventual lean can be steeper. Policy decisions happen in specific legal and economic contexts, and no two countries are identical.

Risk sentiment: the fuel behind the move

Carry trades also depend on mood. Investors talk about "risk-on" when they feel optimistic and are willing to hold riskier assets, and "risk-off" when they retreat into familiar safe havens. The yen and the franc are classic places to retreat, partly because they are funding currencies and partly because investors trust them in times of uncertainty.

In the August 2024 episode, the unwinding of carry trades pushed the yen up and hit higher-yielding currencies hard. The Mexican peso and Brazilian real fell, while some Asian currencies strengthened alongside the yen. That pattern is common: in a risk-off moment, money flows tend to reverse the carries that were built earlier.

It is worth noting that not every sharp move is a catastrophe in disguise. The BIS found that, while equity volatility jumped dramatically, foreign-exchange volatility rose less than in some past crises. Credit markets stayed relatively calm. The turbulence was sharp but short-lived, and markets largely recovered within days. Still, the episode highlighted how sensitive markets have become to any news that hints at slower growth.

The bottom line

Carry trade unwinds are not a new phenomenon. In 1998, the yen strengthened sharply in a short period, and analysts attributed the move to a sudden reversal of carry positions. The same basic mechanics have been visible in different currencies at different times.

If there is a lesson, it is about humility. The size of carry positions is notoriously hard to measure, and many factors other than carry trading move currencies. Official statistics can only give an indirect picture. So when you see a headline about the yen or the franc surging, you can read it as a story of cheap money, borrowed confidence and shifting sentiment. It is not a signal to buy or sell anything, and it is certainly not a promise of what happens next.

The next time a currency jumps overnight, you will know what is happening behind the scenes: a quiet wager, an unexpected change in expectations, and everyone trying to leave the same trade at once.