I’ve been asked about fifty times this week what a carry trade is. If you follow financial media at all, you have probably already gotten a brief overview over the last 72 hours of the process, but let’s just take a moment to review.
In a carry a trade, an investor borrows money at a low interest rate in one currency and uses it to invest in assets that offer a higher return in another currency. The goal is to profit from the difference between the borrowing cost and the return on investment.
For a few years now, investors have been:
1.) Borrowing yen (at a low interest rate)
2.) Converting yen to USD (at a high interest rate)
3.) Investing USD into high yield assets
4.) Profiting from the difference between the high yield and the low cost of borrowing
Since 2016 Japan's interest rates have been rock bottom (actually negative), so the environment has been something like a carry trader's candy store. …Until last week, when the Bank of Japan (BOJ) unexpectedly hiked rates for the second time since March.
We are now experiencing The Great Unwind. The BOJ stopped buying their own bonds and hiked rates, causing the USD vs. JPY to tank, and everyone who had short positions borrowing on Yen had to cover their trade. Basically, everyone had to dump their tech stocks and equities here to cover their short positions in Japan.
How many market participants were involved in this kind of trading? Massive institutions were involved in these carry trades and the BOJ balance sheet is vastly larger than the country’s gross domestic product (GDP)-- it’s currently at 127.5% of GDP. To put that in perspective, the Fed’s balance sheet is only 25% of GDP. In other words, the BOJ balance sheet has about 5x more influence on their market than our own central bank’s.
As we discussed here in Insights on Monday, this massive unwinding hit at a pivotal time in our economy as jobless claims surged, manufacturing surveys slumped and construction spending tanked. This allowed the massive fall in the Asian markets to create a much more acute ripple effect than it otherwise might have. While the Yen carry trade appears to be unwinding at the fastest pace since the currency surged in 2007, we think fear of a U.S. slowdown is the main driver of recent stock market volatility and not so much the recent rate hikes by the Bank of Japan.
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Investor psychology during a rout tends to begin with biting fingernails on Thursday, hedging on Friday, get-me-the-f**k-out selling on Monday, and, hey, let’s bounce on Tuesday because I think we overdid it. …And then we re-test the lows set on Monday.
The numbers support this analysis. Prior to this week, the S&P 500 had fallen on a consecutive Thursday, Friday and Monday a total of 582 times, and the subsequent Tuesday delivered an average gain of 0.2% (50% on an annualized basis), according to data going back to 1928 compiled by Bloomberg macro strategist Cameron Crise.
Yesterday, we got a little continuation of the Tuesday bounce before turning south bigly, and we’re up again today. …But the reality is that we are extremely likely to re-test Monday’s lows. At this point, we expect a re-test followed by recovery with an increase in market breadth to the upside.
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I do worry about whether this unwind of the yen carry trade will lead to some large highly levered financial firm failing a la Lehman or Long Term Capital Management. However, the sharp rally in bonds has re-liquefied the long-term treasuries in the banking system and loosened credit conditions-- it’s the exact opposite of what happened when Silicon Valley Bank failed last year.
After JP Morgan upped its probability of a recession to 35% (from 25%) by year end, the market seems to be pricing in a recession, but from a longer term perspective vs this week, we don’t expect one. (If you believe the Bureau of Labor Statistics), there are still over 10% more job openings than people unemployed, relatively low unemployment at 4.3% and a Fed that was already inclined to cut multiple times this year.
That being said, ya wanna see some real fireworks? You’ll get them if CPI comes in a little hot next week.
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