The Long Unwinding Road

The S&P 500 Index hit its last all-time high on July 16th at 5,669. Since then, the market (as of this writing) is down about 8%. However, some stocks, namely Mega cap tech stocks, are down far more. The SPDR Technology Index ETF (XLK) is down 16% since its July 10th high.  

What is driving this move? We are seeing a confluence of events occurring.  

We are finally seeing an unwind of the Yen carry trade. What the heck is that? 

Stay with me. 

The Yen Carry Trade

For years, investors would borrow Yen at their ultra-low rates. They could borrow at a fraction of a percent thanks to Japan’s negative interest rate policy. Investors could then convert their yen to US dollars or any currency really, and viola’ they would have nearly free borrowed money. It’s a fine strategy if currency values don’t change much. But now, the surging price of the yen has eaten away much of the potential profit. 

At the same time, the US and other developed countries had been raising rates to combat inflation brought on by heavy spending following the Covid pandemic.  

Remember, Japan has a lot more debt and their population is demographically speaking, much older than the United States. Their central bank, the Bank of Japan benchmark rate was negative for the last eight years. This was their effort to combat deflation and prevent a stronger yen from harming the country’s export-focused economy.  

The Bank of Japan carried out their second-rate hike at their most recent meeting, effectively ending their negative interest rate policy. At the same time, the Fed is telegraphing that they will conduct the first rate cut of this cycle come September.  

The result is you have Japan’s rates rising and our rates falling, closing that spread between the two. This is resulting in investors closing their yen borrow or carry trade. This is called, “unwinding the carry trade.” 

In terms of currencies, all else equal, if your country’s interest rate rises versus another country’s, your currency will rise in value. As a result, the yen is strengthening since their rates are rising and ours are falling. You can now receive 142 yen for every US Dollar compared to 160 yen for every US Dollar a few weeks ago. 

As the yen strengthens many of these carry trades- the people who borrowed in yen to do so cheaply – are being “margin called.” A margin call is when you are overleveraged as you have too much borrowed funds versus the amount you put in. You are then asked (“forced”) to add more capital. 

Instead of adding new funds, a lot of investors will simply sell the underlying securities to raise cash to cover the debt. This compounds and exacerbates the decline. And further declines cause more margin calls, and it becomes somewhat of a downward spiral. 

There is no way to know the exact size of the Japanese carry trade but most believe it to be the largest trade in the world. According to Societe’ Generale, the unwind of the Japanese carry trade will be the biggest ever. Estimates have pegged it at over $4 trillion. This could continue on for some time if the yen continues to appreciate and rates rise in Japan and fall in the US.  

Catalyst for Recent Rate Movements

But what was the catalyst to our rates dropping causing the yen to strengthen against the dollar? 

Last week we had a sudden shift in sentiment regarding the strength of the US economy. Previously, the thought that a recession could occur near-term was not high as investors bet on a ‘soft landing’ for the economy.  

On Wednesday, we had an economic data point come out far weaker than expected. The ISM Manufacturing index fell to 46.8 (a level below 50 is a contraction). That was the fourth consecutive month of decline and a big surprise as the market was looking for a small improvement in the index, not a large drop. 

On Thursday, we received the Bureau of Labor Statistics initial jobless claims number. This is the number of people across the country that applied for unemployment benefits for the first time. That number jumped far more than expected and is now at the highest levels of the last year. 

 And then the biggy was on Friday with the monthly jobs report which was also far weaker than expected. Just 97K private sector jobs were created, about half of the estimate and the unemployment rate rose to 4.3%, now a full half point above the low – an often looked at signal for the onset of a recession.  

Throwing a bit of accelerant on the flame was news that Buffett sold half of his massive Apple stake- a news item that on its own was likely to drag down the markets a bit.  

The combination of these variables coming out in a short timeframe shifted the market towards a soft landing or “we are slowing but still good” to more towards a potential recession.  

Interest rates plummeted on the news on the expectation that the Federal Reserve would cut rates faster than was previously expected.  

When a drawdown like this happens, it always feels like the end of the world. This is especially true when we haven’t had volatility in quite some time. Economist Hyman Minsky stated long ago that long periods of stability breed instability. That stability can encourage people to take ever greater risk as they tend to forget the past.  

Why does it feel worse? When you have good times for a long period of time, even routine ‘bad times’ can feel extremely painful. The chart below shows just how calm markets have been in 2024.  

94% of all market years (since 1926) have a drawdown of 5% or worse so this sort of decline is normal. This is why we contain risks in portfolios rather than swing for the fences. Despite the nearly 8% drop in the S&P since July 16th, the index is still up nearly that much so far this year. 

In 2022, the last time the markets took a big dive, stocks and bonds moved down together. That is a rare occurrence. This time, however, bonds are providing their typical buffer against equity volatility. The bond index is up almost 2% in the last week and over 4% over the last month. Many of our clients have seen returns twice that over those periods thanks to move favorable positioning.  

What's To Come...

I would expect a lot of this to reverse over the coming days since this was largely an event triggered by a single catalyst – the Japanese carry trade unwind. As I write this, the 3-month Japanese government bond is now implying that the Bank of Japan will completely reverse their recent rate hike, and even cut more after that. This, of course, makes no sense, and indicates a complete dislocation from selling/buying for forced reasons, not economic reasons.  

In other words, I don’t think this is anything more than a routine sell-off driven by a single unique quirk of the markets (as they typically are). We would advocate turning off the TV and computer and doing something else.  

As always, we appreciate the trust you place in us! 

Sincerely, 

Mark J Asaro, CFA 

Noble Wealth Management