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THE LATEST

CARRY TRADE UNWIND: IS IT REALLY OVER?



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CARRY TRADE UNWIND: IS IT REALLY OVER?

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by Jeffrey Kleintop, Chief Global Market Strategist, Charles Schwab & Company

HAVING BEEN WARNED ABOUT THE RISK, INVESTORS NOW ASK IF THE YEN CARRY TRADE
UNWIND IS COMPLETE. HERE'S HOW FAR IT MIGHT STILL GO.



In our 2024 Global Outlook we warned about the risk posed by an unwinding of the
yen carry trade (borrowing at zero or very low interest rates in Japan and
investing the proceeds in assets with higher expected returns) that shook global
markets last week:



> "Decades of current account surpluses have accumulated, giving Japan the
> world's largest net international investment position (even more than China)
> with $3.3 trillion of investments held abroad according to the International
> Monetary Fund (IMF). Although the U.S. has the largest economic influence in
> the world, Japan may have the largest influence in the asset markets due to
> these account surpluses. Should the BOJ begin to substantially tighten
> monetary policy next year, as signaled by the end of yield curve control at
> the BOJ's meeting in October, the potential for a reversal of decades of
> outward flow of capital may be felt by investors worldwide."
> 
> – 2024 Global Outlook: The Big Picture published December 4, 2023

The yen rose 14% against the dollar in less than a month (July 10 to August 5)
causing assets to decline in value against yen-denominated borrowing used to
fund those purchases, forcing some investors to unwind their trades. The
dramatic moves in markets globally on August 5 indicates this likelihood of
forced selling, similar to a broad-based margin call. A combination of things
likely fueled the recent move in the yen. On July 31, the Bank of Japan (BOJ)
surprised with a bigger than expected rate hike and committed to further rate
hikes along with faster than expected quantitative tightening (reducing the
assets on their balance sheet purchased during a more than decade-long period of
quantitative easing). Additionally, worsening U.S. economic data and some
disappointing updates from some mega cap tech companies weighed on the dollar
and stocks generally.



Going long on tech and short on the yen have been two very popular trades in
recent years. It has been possible to borrow at the cheapest interest rate in
yen, meaning the yen has been the cheapest major funding currency. Since tech
has tended to be consistently profitable, it's not hard to imagine a good
portion of the short yen trade flow has gone into U.S. tech. The chart below of
the similar movement in the dollar-yen exchange rate and the tech-heavy Nasdaq
highlights the likelihood of carry trades funding investments in tech, but the
trade likely funded buying in other markets as well.


CARRY TRADE: LONG TECH AND SHORT YEN

Source: Charles Schwab, Bloomberg data as of 8/8/2024.



Indexes are unmanaged, do not incur management fees, costs, and expenses and
cannot be invested in directly. Currency trading is speculative, volatile, and
not suitable for all investors. Forecasts contained herein are for illustrative
purposes only, may be based upon proprietary research and are developed through
analysis of historical public data. Past performance is no guarantee of future
results.


Is the unwind of the carry trade now over? While it is impossible to say exactly
how big the carry trade is, there are some indicators we can look at to see how
far the unwind could still go on a short-, medium-, and long-term basis.




SHORT-TERM UNWIND

To look at the size of a potential for a short-term reversal, we can examine yen
contracts tracked by the Commodity Futures Trading Commission. On July 2,
speculative investors, like hedge funds, were holding a net 190,000 contracts
betting on a weaker yen (worth about $15.6 billion). By July 31, the day of the
BoJ meeting, those positions were halved and were nearly back to the flat line
by Tuesday, August 6th. While positioning could further unwind and perhaps even
turn long, we feel that most of the extreme short position is unwound.






NEARLY ALL OF THE NET SHORT POSITIONS IN YEN CONTRACTS HAVE UNWOUND

Source: Charles Schwab, Commodities Futures Trading Commission, Bloomberg data
as of 8/11/2024.

Futures and futures options trading involves substantial risk and is not
suitable for all investors. Please read the Risk Disclosure Statement for
Futures and Options prior to trading futures products. Currency trading is
speculative, volatile, and not suitable for all investors. Past performance is
no guarantee of future results.


MEDIUM-TERM UNWIND

A proxy for the medium-term carry trade magnitude is to look at Japanese banks'
foreign lending in yen. This type of lending is often to non-banks, like asset
managers, and has been on the rise since 2010. Foreign lending in yen
accelerated in the last couple of years as rates rose outside Japan, while
Japanese rates remained very low. According to the data released by the Bank of
International Settlements (BIS), the loans totaled $1 trillion (145 trillion
yen) as of March 2024. Unlike investors in futures that are subject to margin
calls that can force urgent selling, asset managers may look to reduce any carry
trades and pay back yen loans over the medium-term, dependent upon their outlook
for currency and rate moves. This means an unwind of this exposure could unfold
over the coming months.







BORROWING IN YEN HAS GROWN TO $1 TRILLION ($145 TRILLION YEN)

Source: Charles Schwab, Bank for International Settlements BIS Quarterly Review
from Bank for International Settlements, June 10 2024.

BIS Quarterly Review from Bank for International Settlements, June 10 2024


LONG-TERM UNWIND

For the longer-term carry trade size, we look to Japan's long-term net
investment position. Japanese investors are the biggest non-U.S. investors in
U.S. Treasuries and among the top five in ownership of non-Japanese stocks.
According to the International Monetary Fund, decades of current account
surpluses have accumulated, giving Japan the world's largest net international
investment position (even more than China) with $3.3 trillion of investments
held abroad as of March 31, 2024. The BOJ's current hawkish bias offers the
potential for a reversal of more than a decade of outward flow of capital to be
felt by investors worldwide. It is unlikely all the outbound investment from
Japan will reverse given the scope of investment opportunities outside of Japan
(and the investment policy of Japan's government-run pension fund which
allocates 50% of the $1.6 trillion fund to foreign stocks and bonds). Yet, it
may not be a one-way flow anymore with some capital repatriated to Japan over
the coming quarters.




JAPAN HAS THE LARGEST NET-POSITIVE INTERNATIONAL INVESTMENT POSITION

Source: Charles Schwab, International Monetary Fund, Bloomberg data in US
dollars as of 8/7/2024.


WHAT ELSE COULD END THE UNWIND?

It has been suggested through various media outlets that perhaps the Federal
Reserve will step in with an emergency rate cut prior to their scheduled
September rate decision. Although softer economic and employment data may prompt
the Fed to join other central banks in cutting interest rates, such a move is
unlikely to halt the unwinding. An emergency cut by the Fed would tend to
strengthen the yen against the dollar exacerbating the carry trade unwind, and
not alleviate it.



Intervention by Japanese officials to limit the rise in the yen is another
possibly. However, prior government interventions to limit currency moves have
tended to be largely ineffective towards changing the yen's trajectory, only
slowing the trend. The BOJ Deputy Governor suggested further moves in interest
rates would take financial market volatility into consideration, which may have
slowed the unwind in the near term.

A return to strong tech stock leadership could reinvigorate the carry trade.
But, there are plenty of issues weighing on the sector which are likely to
maintain volatility: underwhelming earnings outlooks from leaders like Alphabet
and Tesla, the halving of Warren Buffett's stake in Apple, recent economic
data—including the U.S. labor report—missing expectations, heightened global
election uncertainty, and geopolitical conflict.


SAFE HAVEN?

The global stock market sell-off of August 5 saw a turnaround the next day with
when markets rebounded. The bad news? The stock market recovery doesn't
guarantee the risk has been eliminated. We believe that the most dramatic moves
tied to the unwinding of the short-term yen trade may have passed but we will
continue to track the data. For over a decade money was cheaply borrowed in yen
and may have been invested in risky assets like U.S. tech stocks. Ultimately, we
have no way of knowing how long or how far the drag on stocks and currencies
from the 2024 carry trade unwind could go over the medium- or longer-term.



In our opinion, stock markets less exposed to tech, the dollar, and the yen,
along with those that have stable economic backdrops and below-average
valuations, seem the most likely to be better able to withstand any further
unwinding of the yen carry trade. Europe's stock market fared much better than
those of the U.S. or Japan on Monday August 5th, possibly for those reasons. The
market's panicky moves offer a reminder about how portfolio diversification and
a review of risk-exposures is prudent.

 

Michelle Gibley, CFA,® Director of International Research, and Heather O'Leary,
Senior Global Investment Research Analyst, contributed to this report.

--------------------------------------------------------------------------------



Starlight's Dennis Mitchell: Outlook 2024 – Diverse Bets for Uncertainty


Click for sound





1:07:23
●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●
Introduction
Insight is Capital Podcast
Global Rate Cut Cycles
Impact on Equity and Fixed Income Markets
Weakening Canadian Dollar and Inflation
Comparison of Financial Systems
Impact on Canadian Economy
Banking System Comparison
Optimism about Long-Term Trends
Investor Behavior and Home Country Bias
Access to Alternative Assets
Historical Perspective on Investment Options
Importance of Diversification
Concerns About Geopolitical Risks
Authoritarianism and Global Impact
Flashpoints and Political Tensions
Threat of Populism and Governance
Risks of AI Development
Investment Climate and Portfolio Management
Shift from 60/40 Portfolio
The Shift Towards Alternative Assets
Challenges in Embracing New Investment Strategies
Market Receptiveness to Innovative Solutions
The Need for Financial Education
Responsibility of Financial Institutions
Building More Resilient Portfolios
The Importance of Private Assets
Misinterpretation of Private Assets
The Case for Private Investments
The Importance of Private Equity in Client Conversations
Dispersion of Returns in Private and Public Markets
Warren Buffett's Investment Strategy and Private Market Appeal
Fundamental Quality of Investing in Private Markets
Differentiating Between Great Companies and Great Stocks
Assessment of Market Valuations and Investment Decisions
Factors Affecting Returns in Different Asset Classes
Innovation and Return Expectations in Technology and Health Care
Importance of Knowledge and Expertise in Asset Class Understanding
Closing Remarks and Invitation for Future Conversations








 

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Starlight's Dennis Mitchell: Outlook 2024 – Diverse Bets for Uncertainty
1:07:23
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