The financial world is on edge as a massive unwinding of the carry trade continues to reverberate through global markets. This popular trading strategy, which involves borrowing in low-interest currencies like the Japanese yen and investing in higher-yielding assets, is experiencing a significant reversal that has caught many investors off guard.
Yen Carry Trade Unwind Sends Ripples through Global Markets
The Japanese yen has surged against major currencies in recent weeks, appreciating nearly 7% against the US dollar since mid-July. This rapid move has forced many traders to liquidate their carry trade positions, leading to increased volatility across various asset classes.
At the beginning of last month, one dollar was worth more than 160 yen, the highest value in several decades. However, a month later, the same dollar was exchanged for only 142 yen, the lowest since the beginning of the year.
Market experts are closely monitoring the situation, with some suggesting that the unwinding process may only be halfway complete. Historically, Japan's negative interest rates and a weakening yen made it an attractive proposition for investors seeking higher returns. By borrowing yen at low rates and investing in higher-yielding assets, traders could profit from both interest rate differentials and potential currency appreciation.
“However, this dynamic has shifted dramatically in recent months,” explained Michał Stajniak, the Deputy Director of the XTB Analysis Department. “Speculation is rife that the Bank of Japan (BoJ) could raise interest rates as high as 1% in the coming months, while according to the market, the Federal Reserve is expected to cut rates by 100 basis points this year.”
Central banks are now facing a challenging balancing act. The Federal Reserve, in particular, finds itself in a precarious position. While economic data might suggest the need for interest rate cuts, such moves could potentially exacerbate the carry trade unwind and lead to further market instability.
Moreover, the persistence of carry trade unwinding is supported by the behavior of yen futures contracts. “The extreme short positioning in yen futures, which had ballooned to around 240,000 contracts, has contracted to 140,000. In contrast, long positions have surged to 65,000 from a mere few thousand in 2020,” continued Stajniak.
🇯🇵 How Big Is the Yen Carry Trade, Really? – Bloomberghttps://t.co/JuozkWGNPZ pic.twitter.com/4NT39vY0gG
— Christophe Barraud🛢🐳 (@C_Barraud) August 7, 2024
Swiss Franc Tests Decade High
Meanwhile, the Swiss franc has also seen significant gains as investors seek safe-haven assets. This surge has prompted concerns from Swiss exporters, who fear that an overly strong currency could harm their competitiveness in global markets.
“Although the largest number of carry trades took place on the USDJPY pair, it is also worth remembering that investors also used the franc and Chinese yuan in such transactions, so the current trend of reversal of the situation on the yen may also affect these currencies,” Stajniak added.
At a time when the market fears a recession in the United States, geopolitical tensions have been as high as a tightrope for over two years, and significant volatility in the Japanese financial markets has scared investors, everyone is again looking at the Swiss franc as a potential safe haven in difficult times.
Furthermore, analysts from State Street and Citigroup are convinced that the franc may become the new choice for investors specializing in carry trade, replacing the Japanese yen in the leading position. Although the CHF/JPY currency pair reached levels of 180.0 this year, testing multi-year highs, it has since corrected significantly and is currently testing this year's lows at the level of 170.0.
Global Carry Trades See Massive Unwinding, JPMorgan Reports
A significant portion of global carry trades have been dismantled in recent months, according to a new analysis by JPMorgan Chase & Co. The bank's quantitative strategists estimate that approximately three-quarters of these trades have been unwound, marking a substantial shift in the financial landscape.
JPMorgan's data reveals that returns across Group-of-10, emerging market, and global carry trade baskets have plummeted by roughly 10% since May, effectively erasing gains made earlier in the year. The pace of the selloff has been notably swift, occurring at twice the usual rate observed during carry trade drawdowns.
The sharp rise in the JPY/USD is causing a massive unwind of Yen carry trade positions and contributing to the sharp decline in US stocks. For those who do not understand how this works, a brief explanation
— Adam Khoo (@adamkhootrader) August 5, 2024
1) Many traders were borrowing Jap Yen (JPY) at low interest rates,… pic.twitter.com/sfi0Hva56M
“A substantial portion of these trades, estimated at $200–250 billion, has been unwound in recent weeks alone,” added Stajniak. “JPMorgan estimates that as much as three-quarters of carry trade positions have been closed, wiping out gains accumulated from the first half of this year.”
Despite the significant unwinding, JPMorgan strategists caution that the global carry trade strategy currently offers limited appeal. “The yield on the basket has plummeted since the highs of 2023 and is not a sufficient compensation for holding EM high betas through US elections and the risk of further repricing of low yielders if US yields fall,” explained Meera Chandan, analyst at JPMorgan Chase & Co.
The implications of this unwinding extend beyond the carry trade itself. Value strategies have seen appreciation, while foreign exchange rates' momentum has regained ground as currencies realign with interest rate directions.
Carry Trade 101
Imagine an investor borrows Japanese yen at a 0.1% interest rate and uses it to buy Australian dollars, which offer a 3% interest rate. If the exchange rate stays constant, the investor could potentially earn a 2.9% profit from the interest rate difference alone.
While carry trades can be profitable, they come with significant risks:
- Currency fluctuations can quickly erase profits or lead to losses
- Changes in interest rates can affect the trade's profitability
- Economic and political factors can impact currency values
Many traders use leverage to amplify potential returns from carry trades. While this can increase profits, it also magnifies risks. For example, using 20:1 leverage could turn a 3% interest rate differential into a 60% annual return—but losses would be equally amplified.
Carry trades tend to perform well in stable economic environments with clear interest rate differentials between countries, low market volatility and strong risk appetite among investors.
