Last week, we discussed how multiple soft economic data releases turned the market downward. And as impactful as those reports may have seemed, it is never just one thing that spooks the market. It is typically a range of factors, from weak U.S. economic data to heightened tensions in the Middle East to the Japanese yen carry trade. As we’ve already discussed the first topic and most people are aware of how an escalated war could impact economies, let’s focus on what a “carry trade” is and why it brought extreme volatility to the market this week.
In its simplest form, a carry trade is when an investor borrows money from a country with low rates and a weak currency—such as Japan and the Japanese yen—and then invests that money in assets of another country with a higher rate of return and a stronger currency, such as the United States and the dollar. See below for a diagram that shows a fundamental example of how this works.
It’s all good, right? This is a no-brainer, easy money: First, borrow yen at nearly zero percent. Second, convert your newfound yen to dollars. Third, invest in the safety of a U.S. Treasury bill yielding five percent (note: you can use the money to invest however you like). That is all simple enough; what could possibly go wrong? Let’s go back to the illustration to look at the three numbered items for potential hiccups:
- Borrowing rate: If the rate at which you’re borrowing funds increases, this puts pressure on the “cost” side of the equation.
- Exchange rate: If the exchange rate moves unexpectedly (in this case, weaker dollar / stronger yen), this puts pressure on the conversion back to the borrowing currency.
- Rate of Return: If the rate at which you are investing moves lower, this puts pressure on the “return” side of the equation.
If any of these three items moves against you in a carry trade, it can quickly cause the profit margin of the trade to deteriorate. However, if all three move against you, it can be calamitous. And that is precisely what happened over the last week:
- The Bank of Japan (BoJ) announced a surprise rate hike last week, impacting the borrowing rate. This surprised the market, as the BoJ was expected to leave the rate unchanged. In addition, they signaled the likelihood of more rate increases and a significant slowing of their bond purchases, all of which drove up the borrowing rate.
- Given the BoJ’s relative hawkishness and the recent weakness of economic news from the U.S., the yen has appreciated rapidly against the dollar. The dollar has dropped 10% in less than a month. In our example above, the currency impact alone would leave a shortfall of ¥550,000.
- With U.S. markets recently showing concern about a slower economy, rate expectations have moved considerably lower, impacting short-term yields, which has put additional pressure on these trades.
Needless to say, the simultaneous move of all three items put a massive strain on the traders using this strategy (think highly leveraged hedge funds). In fact, the Nikkei 225 plunged 12.4% in Monday trading after falling 5.8% the prior Friday. But why did this impact U.S. markets?
First, remember, nothing states that money borrowed on a carry trade has to be invested in safe assets. Traders can use it for other, more speculative bets, which is typically the case. The carry trade can be used as a means to access cheap money and lever up a portfolio. With that in mind, the simplest explanation I’ve seen of the broader market impact is from Bloomberg columnist Matt Levine. Excerpt:
Market crashes usually have the same mechanism. People like a thing, so they buy it, so it goes up. More people like it, so they buy more of it, so it goes up more. It goes up steadily enough that people think, “ehh, I should borrow some money to buy even more of this thing,” so they do. Eventually a lot of very leveraged investors own a lot of the thing.
Then something goes wrong with the thing, its price goes down, the leveraged investors get margin calls, and they have to sell the thing to pay back their loans. Their losses are big enough that they have to sell other things, things that were fine, to pay back their loans on the thing that went wrong.
The big leveraged investors who owned a lot of the thing that went wrong also all own the same other things, also with leverage, so there is a generalized crash in the prices of the things that big leveraged investors own.
Currently, the best hypothesis is that the leveraged investors exposed to the yen carry trade also had exposure to tech and AI-related stocks that have carried the market for much of the year. In order to cover the carry trade, they had to sell something, which creates the spillover effect Levine discusses in his article.
The current unknown is how big the carry trade is and how much exposure, if any, is left to work its way through the markets. The good news is that markets stabilized throughout the week, with the Nikkei 225 up 10% on Tuesday after its Monday decline, and the U.S. markets rose slightly as well. At the very least, this week was another great reminder of the complexity and interconnectedness of global financial markets. It is never just one thing.
Economy
- Volatility returned with a vengeance this week as markets moved up and down quite dramatically. But, at the end of the week, the S&P 500 was flat, the Nasdaq was down -0.2%, and the small-cap Russell 2000 was down -1.3%.
- The U.S. ISM Services PMI rose to 51.4 in July from 48.8 in the previous month, above market expectations of 51, indicating a moderate rebound in U.S. services activity.
- The S&P Global U.S. Composite PMI was revised lower to 54.3 in July from the preliminary estimate of 55, a slight decrease from June’s 54.8. However, the revised reading still signaled a solid monthly expansion in private-sector business activity.
- The number of people claiming unemployment benefits in the U.S. fell by 20K to 230K for the period ending August 3rd, below market expectations of 240K. This follows an upwardly revised 250K in the previous week, the highest in a year.
Stocks
- U.S. equities were in negative territory. Materials and Consumer Discretionary led the decline, while Industrials and Energy outperformed. Growth stocks led value stocks, and large caps beat small caps.
- International equities closed higher for the week. Emerging markets fared better than developed markets.
Bonds
- The 10-year Treasury bond yield increased 15 basis points to 3.94% during the week.
- Global bond markets were in negative territory this week.
- High-yield bonds led for the week, followed by corporate bonds and government bonds.
