The recent market turmoil was sparked by the unraveling of carry trades. Investors had borrowed cheap Japanese yen to invest globally, but rising Japanese interest rates forced them to unwind these positions, triggering massive sell-offs.
What the duck just happened.
If you’ve been keeping an eye on market news, you may have started the week hearing the term “carry trades” streaming across news and social media sites. In this article we’ll unpack what a “carry trade” is and how it can go wrong.
On Monday 3rd August, the US stock markets had their worst trading day in nearly two years. We know about all the data that bubbles under the surface, but it is very difficult to know what the final straw will be or when it will land on the camel’s back!
In this instance, the final straw was the US unemployment data that pushed higher, leading investors to believe that the US is heading towards a recession, and because of that, the Fed would cut interest rates. Right. That is a bit simplistic, but that is the start. It is ironic, because we’ve been expecting interest rate cuts since the middle of last year!!
So then, what is the “Carry Trade” and why does it matter?
For 30 years Japan has had 0% interest rates on their currency.
As a result, investors borrow Yen at no cost, and invest it globally. They invest in USD Treasury Bills, but also in other more risky assets (like the Nasdaq).
For the first time in many years, the Bank of Japan has started raising interest rates. They started by raising from 0% to 0.1%. But then last week, they hiked rates to 0.25%. It doesn’t seem like a lot, but that is the highest rate since 2008! As recently as April of this year, Japan had negative interest rates!
As a result of the increased interest rates, investors are now concerned that the money they borrowed “for free” isn’t free anymore, and they start unwinding their trades and sending the money back to Japan.
The estimated quantum of this combined trade is $4 trillion!! That is a big number!
The carry trade is all fine and dandy as long as currency exchange rates are far apart, but as Japanese rates went up, and US rates were expected to drop, traders can get tripped up by the currency movements (the Yen appreciated against the dollar) and suddenly there is a mad dash for the door!
The timing was also unfortunate as it all happened after the US markets had closed on Friday night. There is a saying on Wall Street that says, “if you can’t sell what you want, sell what you can” and that is pretty much what happened. The crypto markets were hit first as they trade round the clock, and then sales moved onto currencies, equities and other assets once the futures market opened on Sunday night.
These fears essentially gave the market, which was already nervous about the labour market softening, a reason to sell off further. However, it is my opinion that this has more to do with positioning than less to do with true fears of a US recession. As Michael Batnick, director of Ritholtz Wealth Management said, “Allow me to offer a positive outlook on what looks to be a very ugly day. This is an unwind: margin calls, leverage, selling everything, etc. I would rather have this type of selloff than one that is caused by earnings tanking and a re-rating in the stock market multiples.”
Volatility is a feature of equity markets, not a bug. Times like this are the reason equities pay a risk premium over cash, bonds and other lower-risk assets. It is the price we pay for the longer-term higher returns. The economic cycle is not at a peak, and inflation is falling, not rising and therefore financial conditions are okay. I think this is a nasty flush out of leveraged trades and a bit of a reset in the market. The carry trade probably isn’t over yet, but a lot of people are closing their positions. No one wants to be the last person standing when the music stops.
Here are some interesting titbits:
In 2022, the S&P 500 peaked at 4,130.29 on July 29 and then sank 13.4% to 3,577.03 on October 12th.
In 2023, the S&P 500 peaked at 4,607.07 on July 27th and then sank 10.6% to 4,117.37 on October 27.
In 1990, the S&P peaked at 368.95 on July 16th and then fell 20% to 295.46 on October 12th, mostly in response to Saddam Hussein’s invasion of Kuwait on August 2.
Then, in 1998, in a carbon copy of 1990, the S&P peaked at 1,186.75 on July 17th and then fell 19.2% by October 8th.
Maybe the message is to zoom out, and relax. Let’s re-assess at the end of September. Perhaps it shouldn’t be “sell in May and go away” but rather, “Sell in July, and wait for October to buy” 😉.
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.
What the duck just happened.
If you’ve been keeping an eye on market news, you may have started the week hearing the term “carry trades” streaming across news and social media sites. In this article we’ll unpack what a “carry trade” is and how it can go wrong.
On Monday 3rd August, the US stock markets had their worst trading day in nearly two years. We know about all the data that bubbles under the surface, but it is very difficult to know what the final straw will be or when it will land on the camel’s back!
In this instance, the final straw was the US unemployment data that pushed higher, leading investors to believe that the US is heading towards a recession, and because of that, the Fed would cut interest rates. Right. That is a bit simplistic, but that is the start. It is ironic, because we’ve been expecting interest rate cuts since the middle of last year!!
So then, what is the “Carry Trade” and why does it matter?
The carry trade is all fine and dandy as long as currency exchange rates are far apart, but as Japanese rates went up, and US rates were expected to drop, traders can get tripped up by the currency movements (the Yen appreciated against the dollar) and suddenly there is a mad dash for the door!
The timing was also unfortunate as it all happened after the US markets had closed on Friday night. There is a saying on Wall Street that says, “if you can’t sell what you want, sell what you can” and that is pretty much what happened. The crypto markets were hit first as they trade round the clock, and then sales moved onto currencies, equities and other assets once the futures market opened on Sunday night.
These fears essentially gave the market, which was already nervous about the labour market softening, a reason to sell off further. However, it is my opinion that this has more to do with positioning than less to do with true fears of a US recession. As Michael Batnick, director of Ritholtz Wealth Management said, “Allow me to offer a positive outlook on what looks to be a very ugly day. This is an unwind: margin calls, leverage, selling everything, etc. I would rather have this type of selloff than one that is caused by earnings tanking and a re-rating in the stock market multiples.”
Volatility is a feature of equity markets, not a bug. Times like this are the reason equities pay a risk premium over cash, bonds and other lower-risk assets. It is the price we pay for the longer-term higher returns. The economic cycle is not at a peak, and inflation is falling, not rising and therefore financial conditions are okay. I think this is a nasty flush out of leveraged trades and a bit of a reset in the market. The carry trade probably isn’t over yet, but a lot of people are closing their positions. No one wants to be the last person standing when the music stops.
Here are some interesting titbits:
Maybe the message is to zoom out, and relax. Let’s re-assess at the end of September. Perhaps it shouldn’t be “sell in May and go away” but rather, “Sell in July, and wait for October to buy” 😉.
Asset Class Returns
The table below represents a rolling year view of the major asset class returns that we track. It offers a view of the asset classes we use to diversify your portfolio.