The Carry Trade That Breaks Every Cycle

The Trade That Prints Money (Until It Doesn't)

In the summer of 2007, a hedge fund manager in Greenwich, Connecticut, explained his strategy to a group of investors. It was so simple it sounded like a joke:

"We borrow yen from Japan at 0.5% interest. We convert it to dollars and buy U.S. Treasury bonds yielding 5%. We make 4.5% on the spread — and we leverage it 20 times. That's 90% annual returns with no risk. It's the closest thing to a money printer ever invented."

— Hedge Fund Manager, July 2007

The room nodded. The logic was impeccable. The track record was flawless. The fund had produced positive returns for 43 consecutive months.

Fourteen months later, that same fund had lost 97% of its value. The manager had lost his home. Two of his largest investors had filed lawsuits. And the yen carry trade — which had seemed like perpetual motion — had unleashed a cascade of destruction that contributed to the worst financial crisis since the Great Depression.

This is the story of how a "simple" trade breaks markets. Again and again. And again.

What Is a Carry Trade?

The carry trade is built on one of finance's most fundamental principles: interest rates differ across countries.

Right now, Japan's central bank keeps rates near 0.1%. The U.S. Federal Reserve holds rates at 5.5%. That's a 5.4% difference. And that difference is where the "free money" comes from.

The math seems irresistible:

With 20x leverage — common in institutional currency trading — that $36,000 profit becomes $720,000. Every year. Forever. As long as nothing changes.

The Hidden Assumption That Kills

There's a fatal flaw in this beautiful logic. And it's hiding in plain sight.

The carry trade only works if currency exchange rates stay stable.

When you borrow yen and convert to dollars, you're not just betting on interest rates. You're betting that the yen won't strengthen against the dollar. Because if it does, your profits vanish — or worse, become catastrophic losses.

Here's the cruel irony: the longer the carry trade works, the more confident everyone becomes, and the bigger the positions grow. When the unwind finally comes, the magnitude of destruction is proportional to how long people believed it would last forever.

"Carry trades are like picking up pennies in front of a steamroller. You make small, steady profits — until the steamroller suddenly accelerates and you can't get out of the way."

— Anonymous Currency Trader

1997: The First Great Unwind

The carry trade has destroyed markets before. Let me take you back to 1997 — the Asian Financial Crisis.

Throughout the early 1990s, traders discovered a variation of the carry trade: borrow dollars (cheap, stable) and invest in Thai baht, Indonesian rupiah, and Malaysian ringgit (high yields, "pegged" to the dollar).

The logic was bulletproof: these currencies were officially pegged to the dollar. How could they move? Free money.

The "pegged" currencies that couldn't move? Thai baht fell 55%. Indonesian rupiah fell 84%. The carry traders who had made steady 10% returns for years lost everything — and then some — in weeks.

2008: The Yen's Revenge

Fast forward to 2007. The world had forgotten 1997 — or convinced itself that "this time is different."

The yen carry trade had grown to an estimated ¥16 trillion ($150 billion equivalent). Hedge funds, banks, pension funds, even retail investors in Japan were borrowing cheap yen and investing in everything from Icelandic bonds to Australian real estate to U.S. mortgage-backed securities.

The carry trade was everywhere. And no one saw it.

"We estimated that yen carry trade exposure had become so large that if it unwound rapidly, it would cause a global liquidity crisis. Our estimate was too conservative."

— IMF Internal Memo, 2007 (leaked)

Then came August 2007. Credit markets began seizing. Fear crept in. And the yen — which had weakened for years as everyone borrowed it — started to strengthen.

A 30% move in a major currency pair is unthinkable. It's the kind of move that "can't happen." But it did. And every carry trader who was leveraged 10x, 20x, 50x was destroyed.

The unwind accelerated the global financial crisis. As carry traders liquidated positions, they had to sell their high-yielding assets — emerging market bonds, mortgage securities, equity positions. The selling begat more selling. Prices crashed. Fear became panic.

The Mechanics of Catastrophe

Why does the carry trade unwind so violently? Because of a phenomenon called reflexivity — where the trade itself changes the conditions that make it work.

This is why carry trade unwinds are so violent. Each forced liquidation strengthens the funding currency more, triggering more liquidations. It's not a gradual reversal — it's a avalanche.

August 2024: History Rhymes Again

You might think we learned our lesson. You'd be wrong.

In August 2024, the yen carry trade imploded again. After years of near-zero rates in Japan while the rest of the world hiked, the Bank of Japan suddenly raised rates. The yen surged 12% in three weeks.

"We estimate approximately $20 trillion was at risk in yen-funded carry trades. When those began unwinding, it created the most acute global liquidity stress since March 2020."

— Deutsche Bank Research, August 2024

The August 2024 unwind was a warning shot. The carry trade survived — barely. But the positions are still there. The next unwind will be worse.

Why The Trap Never Dies

If carry trades are so dangerous, why do they keep happening? Because they're structurally irresistible.

The carry trade will always return because it exploits fundamental human psychology and institutional incentive structures. The next big carry trade is already forming. The question is not if it will blow up, but when.

The Current Danger Zones

Where are the carry trades hiding today?

"The most dangerous carry trades are the ones you don't realize are carry trades. Every high-yielding investment funded with borrowed money is a carry trade wearing a different costume."

— Ray Dalio, Bridgewater Associates

Survival Rules

If you're exposed to carry trades — directly or indirectly — here's how to not be the victim:

The Eternal Return

The carry trade that breaks every cycle will break the next cycle too. This is not pessimism — it's pattern recognition.

Right now, somewhere in the world, a fund manager is explaining to investors how their carry strategy is "different." How they've "managed the risks." How the trade has worked for years.

And right now, somewhere in the same world, a central banker is preparing to do something unexpected. A currency is about to move. A funding source is about to dry up.

When those two realities collide — the comfortable assumption and the unexpected shock — the destruction will follow the same script it always has:

Stability → Confidence → Crowding → Shock → Panic → Devastation

The carry trade is the financial world's equivalent of the Greek myth of Sisyphus — an eternal cycle of building and destruction. Except in this version, it's not a boulder that rolls back down the hill. It's your net worth.

The trade that looks like free money always costs everything in the end.