Carry-Trade Explosion Haunts Markets Shaken by Unwind Rapid-Fire

(Bloomberg) — So far, last Monday’s global market crash looks more like a brief tremor, a fleeting panic triggered by a small policy shift by the Bank of Japan and resurgent fears of a U.S. recession.

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But how it unfolded so quickly — and just as quickly disappeared — exposes how vulnerable markets are to a strategy that hedge funds have exploited to bank hundreds of billions of dollars in bets on nearly every corner of the world.

Yen trading, as it is known, was a surefire recipe for easy profits: just borrow in Japan, the world’s last haven of ultra-low interest rates, then convert it into Mexican bonds yielding over 10%, rising Nvidia shares or even Bitcoin. When the yen continued to fall, the loans became even cheaper to repay and the payments became much higher.

Then, seemingly suddenly, investors abandoned the trade, in turn contributing to a furious rally in the yen and a rapid exodus from stocks and other currencies as traders dumped assets to meet margin calls . It also rattled Japan’s stock market, triggering the fiercest one-day selloff since 1987 on worries that the currency’s rise would hurt exporters.

“Yen trading remains the epicenter of all markets right now,” said David Lutz, head of ETFs at JonesTrading.

The pressure has been building for weeks, as markets in carry-trade hot spots crumbled, the Nasdaq 100 fell from record highs and concerns grew that the Federal Reserve had kept monetary policy too tight for too long.

Then came the spark: an interest rate hike in Japan. The BOJ’s benchmark is now just 0.25%, the lowest in the industrial world, but the rise late last month was big enough to force investors to rethink their long-held belief that Japanese borrowing costs would always remain fixed close to zero. .

Even as markets have stabilized, the episode raises alarm bells about the degree of leverage built up around Japan as the central bank continued to pump out cash despite rising post-pandemic inflation. This has left anxious traders trying to gauge whether the bulk of the pullback is over or whether it will continue to ripple through the markets in the coming weeks.

Finding an answer is difficult because there are no official estimates for how much money is tied up in shipping transactions. According to TS Lombard’s GlobalData, the strategy has accumulated about $1.1 trillion, assuming all of Japan’s foreign borrowing since the end of 2022 has been used to fund it, and domestic investors have leveraged their foreign purchases .

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After last week’s dramatic rally, strategists at JPMorgan Chase & Co. reckoned that three-quarters of global currency trading has now been closed, while those at Citigroup Inc. they said the current level of positioning has taken the markets out of the “danger zone. .”

But others such as BNY believe the recovery still has room to play, potentially driving the yen towards 100 against the US dollar – down more than 30% from where the currency pair ended last week.

“A further pick-up in shipping looks likely, but the most significant and destructive part of this bubble burst is now behind us,” Steven Barrow, head of G10 strategy at Standard Bank in London, said in a note to clients last week .

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“The fact is that the yen is still deeply undervalued, and as the Fed begins to loosen its policy, those remaining carry trades are looking increasingly precarious. But Monday’s episode was all about the markets, and it’s not about to cause a negative feedback loop for the real economy.”

— Ven Ram, macro strategist

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The bubble, as Barrow called it, has roots going back decades. In the 1990s, with Japan’s economy overshadowed by a housing crash, policymakers there cut interest rates to zero. Trade was even blamed by International Monetary Fund economists for playing a role in the 2008 financial crisis.

By 2016, the BOJ had pushed rates into negative territory.

The incentive for speculators to borrow in Japan increased as other central banks began to rush to limit the steep rise in inflation after the world reopened from the pandemic. As rates were raised around the world, the BOJ kept its benchmark below zero – widening the profits that could be made from carry trades.

The result was a flood of speculative cash flowing out of Japan, putting downward pressure on the yen as traders sold the currency to buy those in countries where they were investing the proceeds.

The impact was particularly strong in Latin America, which offered fares well above those in the US and Europe. In 2022 and 2023, currencies such as the Brazilian real and the Mexican peso rose sharply to become some of the best performers in the world.

To one extent, borrowing in yen and investing in Mexico, for example, produced returns of 40% last year alone. The strategy continued to add to gains, with yen-backed trades in a basket of eight emerging market currencies returning just over 17 percent this year through early July.

“For a longer time, the peso was a no-brainer just a few months ago – but those days are definitely behind us,” said Alejandro Cuadrado, head of global FX and Latin America strategy at Banco Bilbao Vizcaya Argentaria SA from New York.

When the yen began to bounce back sharply from its weakest levels in decades, it created a feedback loop as traders ran trades to lock in their gains – pushing the yen further as investors purchased to close their loans. It accelerated after the BOJ raised rates on July 31 for the second time this year, and surprisingly weak US jobs numbers fueled fears the Fed may have waited too long to reverse course.

After the recovery hit Japan’s stock market on Aug. 5, sending the Nikkei down 12 percent, BOJ Deputy Governor Shinichi Uchida stepped in to reassure investors that the central bank would not raise rates as long as market volatility persisted. Markets have steadied, with signs that hedge funds have withdrawn some bets that the yen will continue to gain.

The recent reversal has, at least temporarily, dampened the carry trade, with traders anticipating more volatility in currency markets this year.

“No deal lasts forever – and the facts have changed,” said Jack McIntyre, senior portfolio manager at Brandywine Global Investment Management. “The BOJ tightened and something broke — in this case, the carry trade.”

–With assistance from Srinivasan Sivabalan, Zijia Song, Tania Chen, Ruth Carson, Catherine Bosley and Jessica Menton.

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