Is Carry Trade Chaos Ready?

Yen trading is in the news again… what it is, why it developed and why it’s going wild… the stocks most affected… its impact on the ‘Great Tech Reversal’

Why do stock prices fall when the Fed is set to cut interest rates to prevent a recession and stop the unemployment rate from rising by stimulating economic growth?

We saw the answer in early August: the carry trade (yen) is still going.

That came from Louis Navellier’s favorite economist, Ed Yardeni, over the weekend.

Meanwhile, here’s Steve Barrow, head of G-10 strategy at Standard Bank, from late last week:

The rollout of the Carry trade poses a serious threat to any optimal view of risk assets going forward…

Despite the fact that a modest and steady Fed rate cut profile could be for riskier assets, (the Bank of Japan) could blow all of that out of the water if its rate hikes created a huge carry-trade run.

Let’s take a step back…

Between August 1 and August 5, the S&P 500 fell 6%, while the Nasdaq fell 8%. While such sudden and huge pullbacks rarely have a single reason, the unwinding of the yen trade was a big factor.

In recent days, this transaction (and its development) has returned to the headlines. Let’s look at it today to better understand what happened in August and why the risk of associated fallout is still on the table.

Our goal is to correctly assess market risk so that we avoid incorrectly labeling potential future volatility as the start of a bear market and exiting our positions, only to watch for a temporary problem (such as a carry trade) that resolves itself as it goes. what the market is turning. to life without us.

How the yen carry trade works and why it exploded in August

One of the most popular trades in recent decades has been carrying yen. The profitability of this trade comes down to one main thing – arbitrage.

Investors borrow money in yen, where the cost of borrowing has been virtually zero for decades, and then invest in higher-yielding assets elsewhere in the world – mainly the US stock market.

They take their big profits, pay off their cheap yen loan, then pocket the difference.

To illustrate, below we look at the Bank of Japan’s key short-term interest rate dating back to the 1970s. Notice how it has effectively been zero since 2000.

Now, it’s not just Japanese investors who have jumped on the yen.

Given our global economy, investors around the globe have been more than happy to borrow in cheap yen and then invest in US stocks.

But it is difficult to gauge how big the yen trade was (and still is). Analyst estimates were all over the place, ranging from $1 trillion to $4 trillion.

Whatever the number, the takeaway price is the same – this was a very popular trade with an enormous amount of capital involved.

How the shipping trade became so profitable

Older investors will remember the Japanese stock market bubble of the late 1980s, which peaked in 1989. This was one for the ages.

The Nikkei 225 stock index tripled between 1985 and 1989. At its peak, it had a price-to-earnings ratio of 60. Price-to-earnings ratios for certain Japanese stocks were even more absurd: Panasonic was at about 300. … Nippon Telephone was between 300 and 400…and Sumitomo Realty was over 500.

Meanwhile, the land surrounding the Imperial Palace (about 1.3 square miles) was worth more than all the real estate in the entire state of California.

When this bubble burst, Japan fell into the terrible deflation of the “Lost Decade” of the 1990s (which spanned several decades). The Bank of Japan’s response was 0% interest rates to stimulate growth. However, these 0% rates did not match the collective hangover effect of asset price collapse, debt, population aging and various banking crises.

So inflation was virtually non-existent. This was fertile ground for a very profitable and supported yen trade. And as mentioned earlier, global investors have loaded up.

Now let’s fast forward to the last few years.

Japanese Inflation Finally Takes a Heartbeat, BOJ Response and Yen Risk Carried

After decades of virtually zero inflation, things began to change following the pandemic. Clogged supply chains have driven up costs for all kinds of goods. Then, following Russia’s invasion of Ukraine, energy prices rose higher (Japan is a big energy importer). The yen has also weakened substantially against the dollar, making energy and food more expensive.

To combat all this, the Bank of Japan (BOJ) finally acted last spring/summer.

Behold Reuters from July 11:

The Japanese yen rose nearly 3 percent on Thursday, its biggest daily gain since late 2022, a move that local media attributed to a round of official buying to support a currency that has remained at 38-year lows. years…

The scale and speed of the movement put traders on alert for the possibility of Japanese intervention. The authorities have intervened since the beginning of May to strengthen the yen.

A few weeks later, on July 31, the BOJ officially raised interest rates. Behold CNBC:

Japan’s central bank raised its benchmark interest rate to “about 0.25 percent” from the previous range of 0 percent to 0.1 percent and outlined its plan to scale back its bond-buying program.

This would mark the Bank of Japan’s highest interest rate since 2008.

So what was the effect on the yen?

Remember, a consistent, cheaply valued yen has been the cornerstone of the yen exchange for decades…

Well, here is the price of the yen in dollars over the past year. The vertical peak I’ve circled is the effect of the BOJ’s actions.

We could title this chart “the cost of the yen carry trade explosion.”

Following the rapid appreciation of the yen

As we have just seen, in July the yen began to skyrocket. And in late July, the BOJ raised rates for the first time in years, which strengthens the yen.

Suddenly, newer investors in the yen exchange were looking at a higher price to be in it. Because this trade is often carried out with massive leverage, the combined effect of the yen’s rise has hurt many investors’ returns. So they sold.

But what exactly did they sell?

Well, beyond Japanese stocks, they’ve been selling off a lot of US stocks with a tech focus… which brings us full circle to the Nasdaq’s 8% haircut between August 1st and August 5th – noticeably directly after the July 30 BOJ exchange rate hike.

But isn’t the carry trade officially done now?

This is the million dollar question.

If not, we want to know. Because if/when more relaxation comes, we want to see it for what it is and walk through it with confidence. We don’t want to misattribute market weakness to Wall Street deciding we’re in a recession, possibly causing us to make emotional market decisions that derail our long-term goals.

With all that in mind, let’s get back to Ed Yardeni:

The carry trade is still ongoing.

Expectations that the Fed will cut interest rates while the Bank of Japan raises interest rates are boosting the yen and forcing traders to unwind their carry trades, which were executed when they borrowed yen at near-zero interest rates to buy assets with higher. returns in other currencies, particularly Magnificent 7 stocks and US semiconductors.

There has been a strong inverse correlation between the yen and the Nasdaq 100 since early 2023.

So how much of the trade could be let loose?

A few weeks ago, JPMorgan’s head of global FX strategy, Arindam Sandilya, said it might only be half:

We think the carry-trade relaunch, at least within the speculative investment community, is maybe somewhere between 50% and 60% complete. So, I’m not done, not at all.

At the heart of the problem are two factors: the price at which traders got their yen to fund the trade, and how high the yen goes during their trade.

While we can’t answer the first question, as you can see below, the yen is at its second highest level against the dollar since August 2023, and the momentum is clearly “rising”. This probably represents many traders with their feet held to the fire.

Meanwhile, the BOJ has indicated it will push rates higher, but not while markets are volatile.

from Bloomberg Sunday:

After last month’s market turmoil, Bank of Japan Deputy Governor Shinichi Uchida said the central bank would not raise rates when markets are volatile. Governor Kazuo Ueda has since backed his deputy’s position, while stressing that the BOJ will continue to raise rates if data show Japan’s economy and prices follow the central bank’s outlook.

All in all, the chances of another bout of yen-related market volatility have also increased.

But as we mentioned earlier, we’re featuring this story in today’s Roundup for perspective, not a preemptive defensive stance

The goal here is not to get you out of your positions. It’s to let you know ahead of time why there could be more market weakness. Having this awareness can help investors stay invested instead of misinterpreting it as a “hard landing” to avoid.

Of course, we still recommend sticking to stop-losses while maintaining wise position sizes and a balanced portfolio. But better awareness of potential sources of market volatility can help us guard against fear and make quick decisions.

Meanwhile, this whole discussion plays out in Luke Lango’s “The Great Technical Reversal of 2024,” which he’ll discuss more tomorrow night at 8:00 PM EST.

As we saw above in Ed Yardeni’s chart, the Nasdaq 100 was hit hard by the rising yen. Specifically, Big Tech/AI took it on the chin.

While this is a reason to be cautious about tech today, Luke believes investors should still target top AI tech plays, but with a twist…

Here’s Luke to explain:

The era of Mag 7 dominance in the “AI Era” is coming to an end. A new era—where smaller AI stocks take the lead and shine brightly—is upon us.

In this new era, we were able to see many more individual stock opportunities than we saw in the era when there were only seven growth stocks. It could be much more interesting.

And this new era could be accelerated by a major market event in less than two weeks.

That’s why… to be ready for this big market expansion… I’m hosting a important strategy session tomorrow Wednesday, September 11th at 8:00 PM EST. Click here to reserve your seat automatically.

During the evening, Luke will reveal what he believes to be one of the best investment strategies to capitalize on this potential major market expansion.

I will note that if carry continues to shake up the markets, leveraging some assets while weighing on others, this strategy will help traders find and drive winners.

good evening

Jeff Remsburg