Here’s What Happened To the Markets in the Past Few Days

An Introduction

On Monday morning, investors woke up to plunging stock markets with media headlines suggesting that the sell-off was due to fears of a recession, slowing employment growth, and fears over Israel and Iran, but those were not the primary reason why. In fact, it was the forced unwinding of the “Yen Carry Trade.”

What is the “Yen Carry Trade”?

Lance Roberts, in an article posted on his site today, provides an elementary example of the Yen carry trade as follows:

• “A hedge fund sells short $10 million in Japanese Government Bonds that yield zero percent. (The hedge fund sold an asset they didn’t own, netting the fund $10 million and effectively shorting the Japanese Yen.)
• The hedge fund then buys $10 million in U.S. Treasuries, yielding 4%, capturing the spread between the bonds.
• Then, the hedge fund leverages that $10 million into $100 million (10x leverage) to buy risk assets.

Roberts goes on to explain that (and I paraphrase) the carry trade works well as long as the Japanese Yen does not markedly appreciate but, in fact, the Yen has appreciated more than 15% in the last few weeks. That caused the Japanese banks to exercise margin calls forcing those hedge funds, pension funds, insurance companies, or investors using the Yen carry trade to either put up more collateral or sell the leveraged assets. That reversal and forced liquidation created a vicious spiral by pushing the Yen higher and risk assets lower.

Conclusion

Following the selloff, the BOJ walked back its hawkish stance, with Deputy Governor Shinichi Uchida pledging to refrain from further rate hikes amid market instability. This should provide some relief in the near term, but the broader implications of the yen’s rebound and the carry trade unwind will likely continue to influence markets.

Given these developments, I urge caution. History suggests that the unwinding is not yet complete. In a report dated August 9, JPMorgan says it believes the unwind is about halfway done. What’s more, financial markets are pricing in multiple rate cuts by the Federal Reserve this year, which could further exacerbate the carry trade unwind. In such a scenario, it’s prudent to remain cautious about “buying the dip.”