Probing the Carry Trade

When the Bank of Japan signaled its intention to raise interest rates two weeks ago amid attempts to normalize monetary policy, the theory goes that the potential of the yen's ascent against the dollar suddenly made this borrowing much more expensive. When banks and hedge funds cut back on their borrowing as a result, they had to sell some of the shares they owned with the borrowed capital, causing the downward spiral.

But it's unclear whether an unwinding of the yen carry trade is responsible for setting off this latest round of selling, says Cazenove's economist Paul Schymyck in Malaysia.

"It is still very uncertain as to whether an unwinding of the yen carry trade is occurring," he said in a research note published Friday. "Japanese interest rates remain very low, and Japanese data remains unconvincing -- flat CPI, weak retail sales and wage growth. The BOJ may not raise rates again until the third or fourth quarter, which should keep the yen attractive as a funding vehicle."

To further complicate the argument, some analysts say it happened the other way around: that the unwinding of the yen carry trade is a result of last week's selloff in China rather than the cause. After last Tuesday's nearly 9% decline on the Shanghai Stock Exchange, investors realized that prices were inflated, and the Japanese reacted by unwinding many of the yen carry trades, in turn sending markets plummeting further.