Carry Trade Collapse

The Global Yen Unwind

As we have highlighted previously, we have seen the deleveraging of positions using the Yen carry trade starting from July and in recent times what looks to be an escalation of the unwinding of these positions across the market. We are arguing that the stock market sell off at the beginning of August was in fact a reflection of the unwinding of carry trades prompted by the two hikes in Bank of Japan rates this year.

The first hike was announced on March 19, 2024, from “minus 0.1 percent” to “around 0 to 0.1 percent” and the most recent hike on July 31, 2024, to “around 0.25%”. This 2nd hike has escalated the unwinding as it came as a surprise to the market who'd expected the holding of rates at “around 0 to 0.1 percent”. Maintaining these leveraged market positions using the Yen carry trade requires an even higher yield to compensate for the higher cost of carry. This is not to say the Yen trade is over, across markets a difference in yields of “safe” assets remains attractive. However, for the “risky” assets, such as emerging market currencies, Japanese equities and even cryptocurrency, this is the wake up call for those investors to reassess their position, considering their risk/return ratio.

As the Yen trade unravels, the scale of its reach becomes clearer and with historical examples such as the blow up of Long-Term Capital Management (LTCM) in 1998, it holds a major risk to be on the wrong side of a carry trade. Alongside the unwind there has been speculation of a recession on the horizon. Markets have been heavily watching the narrative surrounding this and reacting cautiously in tandem. The Bank of Japan rate hike came at a similar time to the Fed announcing they’re holding the “target range for the federal funds rate at 5-1/4 to 5-1/2 percent” on July 31, 2024. Following this, worse than expected unemployment figures followed shortly after at 4.3% compared to market expectations of 4.1%.This data point triggered a positive result using the Sahm Recession Indicator which has been used as a predictor of recessions historically. This prompted fear across the market that the Fed has left it too late for a soft landing and there were calls for the Fed to step in with an emergency rate cut.

However, there has been conflicting data regarding the strength of the job market, for example the July CPI held steady and came in on par with market expectations indicating a steady market growth of industries. In Powell’s latest speech at the Jackson Hole Symposium on Aug 23, 2024, he calmed the market with an extremely dovish rhetoric and the market has now began to price in for 100bps of cuts in 2024 (implying at least one 50bps move in the three remaining meetings).

In recent times we have seen a steady recovery of the market following the crash during the first week of August, 2024. For example a 8% recovery can be noted in the S&P 500. It follows that carry trades are considered a technical trade and therefore the execution and unwinding will not affect the actual value of the stock. Although, it may have a short term effect on prices- markets will work efficiently to restore stocks to their fair value. This is explored later in the document.

Beyond the Yen

Emerging market currencies offering a higher yield are prime targets of the carry trades and hence have suffered as a result of the unwind. Since many of these trades are highly leveraged, it is fundamental for traders to assess their positions as small movements in the invested markets can translate to significant losses in the underlying cash borrowed. The unwinding of the Yen carry trade can be seen to trigger an increase in capital inflows back to the Yen resulting in a strengthening of the Yen. Conversely, popular carry trade currencies can be seen to weaken the currency as investors sell off their positions. The further Bank of Japan rate hike in July supports the view that the Bank of Japan is moving towards a hawkish positioning in their policies. The Strengthening of the Yen and weakening of emerging market currencies causes volatility in FX markets.

It’s very tempting to see this as a specific event to the Bank of Japan – that the surprise hike in interest rates was a unique shock factor to traders who had leveraged carry trades on being caught out by the surprise move. However, the event cannot be taken alone and speaks to an underlying risk aversion that has spooked all markets at the end of the Fed’s hiking cycle. Seen in figure 1, both MXN and PLN are high-yielding but “riskier” emerging market currencies correlated by them being unwound in the same way, at the same time, as the market moves to a risk-off sentiment.

All Carries Dropped

In fact, the unwind of the Yen carry trade has come at the same time as the unwind of a host of other popular carry trades. We see this in the chart below, which shows a snapshot of the best and worst performing currencies (against a basket of their peers) during the week after the Bank of Japan’s surprise second hike.

The list of worst performers is populated by currencies offering a relatively high yield, such as the Mexican Peso, Australian Dollar, and the Turkish Lira. These currencies will have seen large outflows back into low-yielding currencies as levered traders return their borrowed capital. These can be noted in figure 2 as a list of top performers in green.

These currency pairs are seemingly unrelated besides offering a significant yield differential that makes them prime targets for carry trades. While the collapse in each of the common carry trade pairs has been explained retrospectively with currency specific factors, to see multiple pairs fall sequentially is a hallmark of the risk-off sentiment in the markets.

As we state above, the unwind in the Yen was not the first, but coincided with the strongest impact across risky assets and the knock-on effect to many other carry trades. We had seen other risk-off examples in this cycle already, including in the widening spread between French and German government bonds. This spread was initially linked to the snap-election in France, but has since remained 70bps wide despite the resolution of the risk of a far-right French government.

A sharp decline can be noted in NKY as seen in figure 3, following the rate hike from “around 0 to 0.1 percent” to “around 0.25%” on July 31, 2024, as investors sell off positions and exit the trade. It is indicative that the Bank of Japan policy was a catalyst for this unwind. This carry trade involves borrowing Yen and investing in Japanese equities. Equites overall are viewed as “riskier assets” with the possibility of a higher yield, therefore this move aligns with other seemingly unrelated assets in different geographies and asset groups. It is indicative of the risk-off sentiment being priced into the market.

It wasn’t just FX and Japanese equities, either. In figure 4 below, an almost instantaneous spike in the VIX, starting on the 1st of August, peaked at 38.57 on August 5 before drifting to levels comparable to before the spike. This was the third largest spike in the VIX’s history, after the 2020 Covid pandemic and 2008’s Great Financial Crisis, and correlates with the aftermath of the Bank of Japan hike on July 31, 2024.

The VIX is often viewed as a "fear gauge", measuring uncertainty through the lens of volatility in the equity market. Historically, during risk-off sentiments, investors will move their money into safer assets such as bonds, causing volatility in the equity market during this transition. This most recent sell off can be seen clearly in major indices- SPX, NDX and NKY.

Crypto Too

As we have noticed in the recent past, Bitcoin has become a macro asset. Given it’s 24/7 trading window, Bitcoin led the move over the weekend before the first real chance to sell the Yen the following Monday. This sounded an early alarm bell for the move, and is the clearest indication yet that the Bank of Japan’s hike was just a trigger for a risk-off event and not a move restricted driven by the unwind of the Yen carry trade alone. After moving sideways in the mid 60Ks throughout July, BTC led crypto assets in a stark sell off.

However, BTC has been slower to recover back to pre-sell off levels, remaining around 8% down from its July high. That it has not recovered as quickly or strongly as well as the core indices explored above and this is likely an indication of more factors at play. While this extra reluctance to retake levels lost in the crash could be attributed to extra political uncertainty in the run up to the US election, we also see the increased volatility as pricing in the uncertainty around the path of monetary policy in September.

If the unwind of carry trades is indeed a symptom of a swift loss of risk-appetite among investors and heralds an impending market crash, then we can look at the historical performance of other risky assets as an indication for the likely response in crypto. BTC data itself can only be used to inform us directly from one previous global market crisis, with liquid trading beginning long after the 2007-08 market crash. However, the case of the Covid-19 pandemic saw a sudden impact on the employment side of the Fed’s dual-mandate – the side that now has markets concerned going into the Fed’s September meeting.

Then, the sudden impact of the pandemic saw a demand for cash, which caused the pairwise correlation between almost all assets to hit historical highs in the selloff. However, it was “risky” assets such as US tech equities where BTC maintained its correlation with during the period of low interest rates and liquidity injections that powered the recovery rally.

That correlation to risky-assets is back. As noted in previous research, BTC’s correlation to US equities has increased since the launch of the ETF which is, in our view, indicative of institutional investors trading the newly accessible asset class alongside other risky assets with an allocation in the same portfolio.

If the loss in risk appetite in early August was indeed an early warning sign (but apparently not the first), then we expect BTC’s correlation to equities to strengthen in any repeat showing of the crash in the short term.

In fact, BTC has most recently increased in correlation to a slew of macro-linked assets. This includes a spike upward in its correlation to US equities as both sold off during the Yen unwind, but also with the growing steepness of the US Treasury yield curve, indicating that expectations of a cutting cycle without a recession are at least in part driving returns.

Markets now begin to price for over 100bps of cuts in 2024 (implying at least one 50bps move in the three remaining meetings) and the yield curve approaches the point of disinversion. Other risky assets currently do not seem too concerned about the risk that the Fed has left it too late to salvage a soft-landing following the jobs market weakness that spooked markets ahead of the Yen-unwind – the S&P 500 trades less than 1% below its all-time high. Despite only seeing one such cycle, BTC showed in the post-pandemic recovery rally just how potent a swift cutting cycle can be in invigorating the performance of risky assets – as seen in the chart above.