Markets under Pressure: Global Sell-offs of Carry Trades Overshadow US Economic Outlook

In recent days, global stock markets experienced a significant downturn, which analysts attribute less to a sudden change in US economic outlook, and more to an unwinding of carry trades used by investors to maximize their bets. While weaker than expected US employment data on Friday acted as a catalyst for the market sell-off, including the largest daily loss of Japan's Nikkei Index since "Black Monday" in 1987, their weakness alone would not have been sufficient to trigger such sharp movements. Instead, the downturn is explained by a decisive unwinding of carry trades, where investors borrow money from low-interest-rate countries like Japan or Switzerland to invest in higher-yielding assets. This led to the liquidation of positions as the Japanese yen recovered by more than 11% against the dollar. Mark Dowding, Chief Investment Officer at BlueBay Asset Management, emphasized that the markets were predominantly influenced by forced liquidations as several macro funds were caught off guard and preset sale levels (stops) were triggered, particularly in relation to currencies and the Japanese yen. He sees no indications in the data that point to a hard economic landing. An Asia-based investor, who wished to remain anonymous, explained that some of the largest systematic hedge funds, which trade based on algorithmic signals, began selling stocks when the Bank of Japan's surprise interest rate hike last week fueled expectations for further tightening. As events unfolded, exact figures and position changes were difficult to ascertain, but analysts suspected that crowded positions in US tech stocks, financed through carry trades, were responsible for their substantial losses. The US Nasdaq Index lost over 8% in the first week of August, while the broader S&P Index declined by 6%. Carry trades, facilitated by years of extremely loose Japanese monetary policy, promoted a boom in yen-denominated borrowing. According to data from the Bank for International Settlements, the volume of cross-border yen-denominated loans increased by $742 billion since the end of 2021. "This is about the unwinding of a yen-financed carry trade and a correction in the Japanese stock market," stated Tim Graf from State Street Global Markets. His data shows that investors are now more balanced in their yen positions after previously being underweight. Speculators have aggressively reduced their short positions against the yen in recent weeks, according to the latest data from the US market regulator. These changes have added additional strains on hedge funds, as they often finance their investments through borrowing. The re-alignment thus exacerbates market movements. A note from Goldman Sachs to its clients indicated that while gross leverage of hedge funds decreased in June and July, it still remains close to five-year highs. Last week, bets on falling stock prices surpassed those on rising prices for the third consecutive time. Asia-centered hedge funds recorded a loss of 7.6% over the last three trading days. Ultimately, analysts noted that while further short-term pain is likely, market disruptions are expected to remain limited. Traders now anticipate over 120 basis points of US rate cuts by the end of the year, compared to about 50 basis points at the beginning of last week. "It is really wrong to fundamentally reassess the outlook now. This would merely be an adaptation of the narrative to the price movements," Dowding from BlueBay stated.