Don't Make the Yen Trade Carry the Weight of the World
The carry trade was a symptom, not a cause, of what we're seeing playing out this week.
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This week is one that will certainly go down in the history books: We saw the largest liquidation in broader indexes since the Global Financial Crisis and the Nikkei down 12% in a day, more than Black Monday in 1987.
These are phrases that are smeared all across the media, with much ink spilled over the cause: the infamous Yen carry trade. Investors have been conditioned to buy any dips in the market and with the one-way path of the yen, this allowed them to borrow in the cheapest currency with negative rates and to then invest in much riskier assets, making a sizeable return not only on the asset itself but also on the carry between the currencies. It worked superbly, till it didn't.
Another result of the constant Fed meddling with quantitative easing on tap was the short Volatility Index trade. New exchange-traded funds were launched to give investors access to this product that sold upside calls to enhance portfolio returns over and above the safe 5% on money markets rates. It was another no-brainer trade to sell volatility that kept falling all throughout last year. The VIX went from highs 20s down to 13 even. Investors were sure that Fed would step in. The hope was an injection of liquidity. But as we saw back in February 2018, and once again this week on Monday, when the VIX rallied from 18 all the way to 65 in a matter of minutes. It took away all those "risk free" returns made over a few years disappear in one morning. There is no free lunch in markets.
Coming into 2024, most asset allocators were all invested in the market, mostly the S&P 500 and technology stocks. Some even used the yen to borrow funds to then invest more into the technology stocks. As the yen exploded higher, it caused global margin calls that saw a selloff in the same assets that were owned. One begs to wonder: If trillions in market cap were gained and lost in a few days, how much of these price moves were fundamental and how much just pure momentum chasing?
The issue is that the Bank of Japan is stuck between a rock and a hard place, as it can either save Japan's currency or the bond markets, not both. The BOJ needs to raise rates to combat inflation, but if it does, it will sacrifice local exporters and some who were even unhedged.
Stress has been building in the macro markets prior to this episode. Since the consumer price index was released on July 11, the bond market has completely un-inverted as the spread between the 10 and two years and is now trading close to parity, when it was as wide as negative 50 basis points. The Fed keeps reiterating that it will stay on hold as it is within a dual mandate. This is even though the entire world is waiting for the Fed to cut so that the eventual fourth-quarter recovery can happen, alleviating the stress on yen and the yuan. Since March 24 print from the Institute for Supply Management, the U.S. economy is showing signs of rolling over in manufacturing and the rate of change of the Core CPI, not including food and energy, shows a very discerning trend in prices.
The Fed has tightened too much. It is not immaculate disinflation, but rather deflationary trend that is taking prices down at a much faster rate. This is why the bond market moved in the way it did a few weeks ago as it is sure that the Fed is about to make a policy mistake. To add to that, the large-cap tech stocks reported stellar earnings, but guidance into the third quarter was softer and no evidence that all their capital spend on artificial intelligence is generating the margin growth that was promised. So, is it not different this time.
It is easy to pinpoint all the troubles on one issue, the yen, truth be told. There are a lot of dominoes falling one by one in the back as the system resets from a world of lower rates and robust growth. Not to mention the uncertainty surrounding the diverging policies going into the U.S. elections. The debt path is unsustainable and neither candidate is interested in cutting back spending.
Investing is all about risk reward, and when everyone is one sided on the same bet even a small spark can light the fire. In 2023, every single analyst thought we were in a recession. After the constant liquidity injections, today not one analyst expects 2024 to see a recession. It remains to be seen if this is a soft patch in the U.S. or the start of a much more sinister move lower. But this is not all on Japan.
