A currency carry trade occurs when people borrow in one currency and invest in another country.
For example, suppose Japanese interest rates are 0% and US interest rates are 5%.
In this case an investor can buy Yen and borrow from a Japanese bank at 0% interest. He can then exchange Yen for Dollars and put the money in a European bank, gaining 5% interest on his savings. Therefore, in theory, he can make a profit of 5% on the difference between Japanese and European interest rates.
Many investors took part in this because, with leverage the potential profit is quite high. (leverage is a way to magnify any
Problems with Yen carry trade
The only problem with the Yen Carry Trade is potential fluctuations in the exchange rates. If the US dollar depreciated then an investor would see his profit wiped out. In a period of exchange rate uncertainty, it becomes less attractive to engage in any currency carry trade.
What happens when Europe cut interest rates?
With the Euro economy going into recession, Euro interest rates are falling and could get closer to Japanese interest rates (Japan rates currently 0.3%)
As the gap between European interest rates and Japanese rates narrows, the incentive to borrow in Yen and invest in European banks declines. Therefore, as European interest rates fall, investors are reducing their holdings of Euros and are paying back their borrowings in Yen. This is one reason why the Euro has fallen. Lower interest rates are making people sell Euro investments.