The carry trade reconsidered
Everyone loves a simple phrase that covers a complex phenomenon — even more so if it sounds a bit sophisticated. Enter “the carry trade”, or, even better, “the unwinding of the carry trade”, which have been rolled out as an explanation for all sorts of market chaos in the past week or so.
We’ve written that we see no evidence that the volatility in US equities, in particular, results from the carry trade. It seems more likely that causality runs in the other direction. After talking to people who understand currency markets and Japanese finance better than we do, we still think this.
Defined most loosely, a carry trade is just using capital from low interest rate countries to buy high-yielding assets elsewhere. This covers all the Japanese institutions and households who have used a cheap yen to invest abroad. Some of this flow may reverse if Japan’s rate differential with the rest of the world continues to close. But that is not what is happening now. Here is James Malcolm at UBS:
Japanese outflows have been largely in the form of foreign direct investment . . . [after the Bank of Japan raised rates] they did not fundamentally alter their risk appetite — Toyota is not closing its factories. They are investing abroad for growth and access to labour. And Japanese [institutional] investors are similar. When they buy foreign equities, it is for earnings growth and diversification. They may have sold off some foreign AI holdings, but it is unlikely that they will start to repatriate in a big way. And Japanese retail investors in particular have few assets offshore.
Defined more narrowly, the yen carry trade is currency desks and hedge funds borrowing yen to invest in other higher-yielding currencies or fixed income products. Malcolm at UBS estimates that since 2011 there has been a cumulative $500bn in dollar-yen carry trades. And the leap in the yen and fall in higher-yielding currencies suggests that the dollar-yen carry trade and some of these other yen carry trades really did unwind:
These trades tend to blow up for two reasons. First, when there is a change in interest rate differentials which make the trade unprofitable. There has been a slow walk away from yen carry trades since March, when the BoJ raised rates out of negative territory. A rush for the exits based solely on the BoJ’s 15 basis point increase last Wednesday seems quite odd.
The second type of trigger is a volatility shock. From Mark Farrington, global macro adviser at Farrington Consulting:
[A volatility event] pushes [traders] to downsize their FX carry positions . . . inputs to the risk management model will be generalised volatility indicators, not necessarily only FX volatility. Large losses in your US equity trades that are dollar funded can still force risk adjustment in your yen funded trades, and vice versa.
So the equity sell-off could have triggered the unwinding of the carry trade, not the other way around. And the timing suggests this is what happened. The equity sell-off did not start in earnest until Friday of last week — two days after the BoJ raised rates, or after currency traders had time to digest the news.
Markets being markets, after the equity sell-off triggered the unwinding of the yen carry trade, the carry trade unwind could have then exacerbated the equity sell off — especially since everyone kept shouting “carry trade!”. But they are separate phenomena, and while the yen carry trade (narrowly defined) seems likely to continue unwinding, that alone does not necessarily imply that global equities must remain under pressure.