ARP's Desk View

ARP's Desk View

ARP Digital's Desk will be sharing weekly insights on relevant flows, and trade ideas to help its trusted partners capitalize on market catalysts.

Events: Carry trade predicates on the basis of borrowing cheap in one currency and investing in a higher yielding currency. In this case of recent events the trade relates to investors borrowing in Japanese Yen and investing in higher yielding currencies such as USD.  The following scenario could help one conceptualize how the trade would work, investor borrows Yen  at 0.25%, the borrowed yen is then converted into a high yielding currency such as USD where interest rates are higher (e.g. 5%), investor would then need to convert back into Yen to pay back the loan and hence net out the spread. The investor benefits from the IR differential (5%-0.25%), and FX fluctuation (if Yen drops relative to USD).

The primary risk in a carry trade is the fluctuation of exchange rates in an unfavorable direction or tightening of the IR spread. If the value of the yen appreciates against the dollar, the investor could end up losing money despite the interest rate differential. On the other hand, if the spread widens and USD appreciates relative to Yen  (as was the case post COVID) the trade becomes even more attractive as the investor would benefit from the spread differential and the appreciation of the dollar. Separately if the cost of borrowing Yen increases then the trade is less compelling, as the investors’ cost of capital is now higher.

Yen: Japan hiked rates 25bps -> largest hike since 2007, on a broader level global liquidity had been tied up in this trade since BOJ kept IR for the last 8 years. Overall, Japanese consumers have seen a depreciating currency and have been borrowing in Yen and investing in higher-yielding currencies abroad (i.e. USD 5%, Peso 10%). When investors borrow in Yen, they do so at a floating rate, if Japan hikes rates, then the investor is no longer borrowing as cheap as they were. When BOJ hiked rates it led to a higher cost of capital on borrowing, and appreciation of the Yen relative to the dollar. When one considers leverage that was involved in the trade then the differential is impactful.

US: Over the couple weeks we saw a number of weakening data points coming out of the US which lead to market jitters of an upcoming recession. ISM Manufacturing Index which measures the health of the U.S. manufacturing sector showed weak numbers. A reading below 50 signals weak data and a contraction in the economy. Forward looking data signaled 46 headlines, and 41 survey. Weak labor market metrics – Below expectation NFP, and Average Payroll earnings. SAHM rule which tracks employment data to predict economic downturns has indicated that the labor market is weakening, precursor for downturns, unemployment went from 4% to 4.3%. Other aspects such as Berkshire liquidating equity positions and going into cash. The probability of a 50bps cut in September doubled following the NFP data, what happens when the fed cuts into a weakening economy and growing unemployment?  The consensus was the Fed was behind the curve on an economy that seemed to be hurting.

VAR: The events resulted in a VAR shock across multiple portfolios in many funds. VAR is a risk mgmt. model which funds use to measure max drawdowns. So, if a fund manager sees a drawdown in one aspect of their portfolio it has a ripple effect across the rest of the line items in the fund, as their risk exposure is actually much higher than initially anticipated. So, if one sees a drawdown in what a concentrated trade was held across multiple funds one would see a ripple effect in which they are forced to pare down risk across all other line items. It has a self-reinforcing effect when Yen is the funder for other pro-cycle trades so it’s essentially a negative feedback cycle. This was pretty widespread across the market. So, it was basically a VaR shock that ended up impacting positions across the board. 

How big is the Carry Trade? It is not clear. Many of the trades are conducted as off-balance sheet transactions and can be quite complex. Some claim it so small as USD$500Bn while others suggest it could be USD$4tn, we saw a sell-side chat mentioning it could be multiple magnitudes higher than that. If one was to compare the subprime mortgage market was about USD$630Bn. If you are interested to learn about the history of the Yen carry trade you need to go back to the Volcker/ Reagan era, Rising rates - Dollar Strength relative to Yen from 80-85, the rise of Japan as an export powerhouse (Japanese cars), the Plaza Accords, and eventually the Japanese bubble bursting.

 https://discussthetape.substack.com/p/the-week-that-matters-29-july-2nd.

How deep are we into the unwind? Hedge fund, CTA -> this flow is basically done (flushed out). However, the main question is what is happening with institutional money in Japan as this is the flow that’s entrenched since 2016. Other flow consists of Japanese retail -> they would have likely been hit with margin calls, and thus are flushed out. The flow that is less clear is institutional flow in Japan. They have $2tn of foreign bond holdings in total, the pension funds have only currency hedged about 45%. Equity holdings are another $1Tn that could be impacted but it’s tough to say. This flow is sticky and has built over multiple years. This could be the next wave of flows to unwind. Hedge ratios are at 45% and they are usually at 60% so if u see the move in Yen one would likely increase the hedge ratio or draw down holding of foreign assets in both these instances one would need to convert back to yen. So, where do we go from here? - The trade is still attractive US rates are still high (for now), and JPY sits at 25bps so yields are still attractive on an absolute basis. If the US avoids a recession there wouldn’t be a real reason to start a reallocation from foreign assets, at the same time we would be going into a market with heightened liquidity, but then again that depends on the data.  

What is interesting to see is what occurred following the unwind was extreme panic and an extreme position unwind. The VIX got to a level that it only got to in ‘08 and Mar ‘20, see attached chart below. BTC IV spiked to 90+ which we haven’t seen since the collapse of FTX.

Where are we now? Historically when the fed cuts rates, how risk assets perform says a lot.  If the economy goes into a recession – risk assets sell off. If the economy is not going into a recession – risk assets rally. The current scenario seems to be more of a 1995 scenario – the Fed did mid cycle rate cut and economy took off. The data is not currently saying we are going into a recession but it is something to keep an eye out for. Ideally you want risk to work but the risk reward is not there anymore given the moves we’ve had in market. Investors already bought what they had conviction in, and Hedge funds have started derisking – early July and mid July.

The funds that caused max pain were the momentum funds – they were max long and had to unwind. There is a reasonable chance we seen low but again it depends on the data. For instance the weekly claims number which is not that imp was good, and the NASDAQ rallied because of it. If the US economy goes to recession then we would have a massive reprice – in a recession we would have that reprice.

So what are the Data point that are important for the classification on where we are? The employment data, and the survey data. We got information from earnings that the consumer is weaker (travel, home appliances etc.) but people generally have overspent on home appliances, and could be reconsidering travel. Earning are showing us the economy is slowing but it might be slowing from 4% last year to 2/2.5% this year.

Tldr:

1)       Yen appreciating and Dollar Weakness which saw USD/JPY crash from 160 to 142. Weaker US news compelled by a BOJ hike led to an unwind of the USD/JPY carry trade. In short it was a combination of multiple factors coincidentally occurring (JPY hike, and Weak US data) which caused the unwind. VAR shock across fund managers lead to further unwind. Hedge Funds, CTA, Retail margin called have been flushed out (first phase), Institutions unwind are not so clear yet. VIX and BTC IV skyrocketed to levels not seen since ’20,’08, and FTX Collapse Nov ‘22.

2)       If there was a fundamental factor at the center of the recent repricing, concern over US growth was it. Economists have taken our estimated probability of a recession in the next 12mths up from 15% to 25%, but are stressing the 75% probability of a continued expansion. Just to de-bunk the jobs scare thesis : “the increase in the unemployment rate has occurred alongside a sudden expansion in labor supply on the back of the 2022-23 immigration surge, not a sudden drop in labor demand.

3)       Concern over some pockets of weakness in low-end consumer. Big brand consumer businesses have their own idiosyncratic issues, however, spend across developed markets is resilient, which is in line with household balance sheet strength, covid era savings (everywhere but the US) and positive tailwinds to real incomes.

4)       US election risk is going to be a major point of uncertainty. Some deem Pols to be inaccurate, but betting markets also give a clear indication of the odds. Polymarket: a betting market shows, Donald Trump at 45% odds and Kamala Harris at 54% chance of winning the US election. Kamal stands a far higher chance than that of Biden, and so far, she’s played a strong hand in re uniting Democrats. Declining to go off script or making any optional public appearances has proven to be rewarding. Kamala understands she must win over 5 states to be in a strong position and has so far played a powerful hand in changing her historic views to appease to new voters.

5)       Monetary accommodation is also supportive for growth, which is relevant when markets have traded and price a growth hit. If monetary accommodation prove to be meaningful then there good be an opportunity to trade in a portion of the market. Although the risk/reward is not where it was 12 months ago. So if markets have stabilized which pockets show strength moving forward?  Will the post summer trend mimic the same leaders we have seen YTD? Post covid era is unique in many ways, it seems increasing clear that the generic cyclical assumption could prove confusing when navigating the next equity market move as the Fed starts cutting.

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