The Carry Trade
Given the volatility in the markets over the past few days, we thought it wise to address our thoughts surrounding it. Please understand that the observations and opinions shared below can change as new information becomes available.
Last Wednesday, the Governor Ueda of the Bank of Japan made a comment that took some investors by surprise. While they announced a rise in overnight rates to 0.25%, the chair mentioned that he could see rates going higher than the market’s expectation of a maximum of 0.5%. One of the most profitable trades in the first half of the year—betting on a weak yen—turned quickly into a very unprofitable trade. Many participants were forced to unwind their levered positions against the yen, causing a mad dash for the exit. That impact was felt around the world.
Before we discuss some of the mechanics as we understand them, let’s cut to the chase: we do not see this as an event that requires a change in our portfolio positioning. When markets adjust quickly, as they did yesterday, there are other factors that can be monitored to see if they may lead more to run to the exits. As of today, we do not see those elements present themselves. We are closely monitoring market activity to see if we can discern a change in the risk environment, but we do not see the typical footprints that would lead us down the path of reducing our equity exposures.
The Yen Carry Trade
We are far from experts on carry trades, but we believe we can offer a 50,000-foot description that may be helpful for understanding yesterday’s market dislocation. Some traders look to take advantage of the differential in global interest rates. They look to borrow in countries and currencies with low interest rates and invest in countries with higher interest rates. Sometimes, they even decide to get greedy and borrow one currency and invest it in another country’s riskier assets. This trade can become even more profitable if the currency that is borrowed depreciates relative to the one purchased.
The analogy to describe this trade is picking up pennies in front of a steamroller. Given the small differences in interest rates, traders need to place a lot on the bet to make a good absolute profit. The steamroller aspect is because if the trade goes against you, losses quickly overwhelm the amount placed on the bet.
That brings us to what happened over the last few days. Last Wednesday’s comments about the potential need for higher rates in Japan caused the yen to strengthen when most people expected it to continue weakening. Traders quickly found themselves on the wrong side of the trade and were forced to change direction (i.e., run for the exits).
The unwinding of their levered positions caused traders to sell assets to pay off the loans denominated in yen. The assets sold were wide and varied, including currencies, equities, and fixed-income securities. Given the need for speed in reducing their trades, they sold indiscriminately, causing yesterday’s swift adjustment.
Of course, with such a surprising drop, fears that this will continue are natural. However, there are items to keep in mind:
- Corporations have feared a recession for over 2 years and maintained a lean structure.
- Employment is slowing, not declining.
- Recent GDP readings have shown positive surprises.
- Consumption continues to be strong.
- Valuations are not stretched outside of the technology segment.
- Corporate earnings are re-accelerating.
We do not want to sound complacent. We have stated many times that our job includes monitoring low-probability events for when they are likely to change into near-term threats to our clients. At this time, the domino that fell over the past few days has not led to others showing signs of toppling.
IMPORTANT DISCLOSURES
This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal.
All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.