What is a carry trade, and how did a small rate hike in Japan trigger a global sell-off?

Why did markets around the world drop sharply on Monday? What does it have to do with the Bank of Japan? And what is a carry trade?

It turns out those questions are all closely related. Read on for the answers.

Why a carry trade may be responsible for the market's current turmoil

For months, market observers have been talking about a popular trade in which investors borrowed in Japanese yen at very low interest rates, and then invested the borrowed money in high-growth investments like the "Magnificent Seven" stocks.

Concerns about the carry trade had been rising for weeks, in part because of the enormous amount of money involved in it − an estimated $4 trillion. Those concerns soared on July 31, when the Bank of Japan raised interest rates from 0.1% to 0.25%.

That rate is still very low, of course, and in and of itself not a big deal for the carry trade. But it was the bank's largest rate hike since 2007, and currency traders took note of the implications.

A small-sounding rate hike had a big effect on exchange rates

The yen reacted almost immediately to the rate hike, rising to about 150 to the U.S. dollar from about 162 to the dollar earlier in July. (We say that the yen "rose" because it gained value relative to the dollar.) The yen has risen even further since, trading at around 143 to the dollar on Monday morning.

If you borrow in yen and then trade in dollars (or euros, which have similarly fallen versus the yen), and then the yen gains value, you have to earn more dollars or euros to pay back your yen-denominated loan.

Consider: If you had borrowed 10 million yen a month ago and immediately converted it to U.S. dollars, you'd have had about $62,000. But given the way the yen has surged recently, you would need about $70,000 to pay back that loan today − even without taking interest and fees into account.

Put another way, you need to have made roughly 13% on that borrowed money in one month just to break even on the loan. That's a much bigger deal than the Bank of Japan's 0.15% interest rate hike.

Why investors are rushing to unwind the carry trade now

Now consider that the Bank of Japan has signaled that more rate hikes are possible. That suggests the yen could rise even further against the dollar in the near future. That's a big incentive to unwind that carry trade in order to pay back the yen-denominated loans as soon as possible.

Given that there was an enormous amount of money involved in this particular carry trade, the unwinding is having massive effects in markets around the world as investors sell stocks and other assets in order to repay those loans.

That's not all that's driving markets lower, of course. There are legitimate concerns about the U.S. economy, after several leading indicators last week suggested that its growth has slowed. But the $4 trillion unwinding is certainly having a major effect. It probably already triggered more selling by investors who weren't involved in the carry trade but who saw big names like Nvidia and Tesla selling off sharply.

Some of the big growth names might bounce in the near term as investors "buy the dips." That's not necessarily a bad idea. Just remember that the selling could resume: $4 trillion is a lot of money.

John Rosevear has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia and Tesla. The Motley Fool has a disclosure policy.

The Motley Fool is a USA TODAY content partner offering financial news, analysis and commentary designed to help people take control of their financial lives. Its content is produced independently of USA TODAY.

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