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The “long Japanese equities/short yen” trade worked until it didn’t. Now that momentum has reversed, cleaning up the mess could drive Japanese stocks lower by another 15 per cent, according to JPMorgan analysis.
You join us as a Japan-led sell-off cascades through global markets, with the Nikkei 225 showing its biggest three-day fall in a lifetime. Weak US non-farm payrolls last week have added growth worries to Bank of Japan’s hawkishness and a dramatic unwind of the yen carry trade. (For an explainer of how carry trades prop up all sorts of markets by funding interconnected leveraged loans, this GFC-era IMF paper is recommended.)
A lot now hangs on whether Japanese stocks can find a floor.
JPMorgan’s Asia quant team, led by Masanari Takada, estimate that foreigners have been quick to exit Tokyo’s spot markets, with around 90 per cent of the stocks bought by overseas investors since April 2011 being dumped over the past few days. Meanwhile, domestic investors will have been squeezed out by margin calls as the yen appreciated.
It’s the offshore commodity trading advisers, or CTAs, who are left holding the bag. Overcrowded momentum trades mean there’s still a big overhang in futures markets that will need to be cleared out somehow, says Takada:
CTAs are accelerating loss cutting, but at the same time, it has been left behind by the sudden market drop. Although the initial movement was driven by futures, the sell-off since last weekend has been strongly driven by spot trading. CTAs positions have been unwound by about 40%, but with NKY falling below 35,000 and TPX falling below 2,400, it is likely that they will be forced to further reduce their positions . If CTA’s Nikkei futures longs are wiped out, it is mechanically calculated that NKY = ~27,000 will come into view.
If spot flows cannot be pushed up to [Nikkei]=35,000 by the end of August, CTAs will likely turn to short positions after clearing out futures longs, and Japanese stocks are likely to enter a bear trend formation phase.
(JPMorgan’s note is in Japanese; the extracts quoted here are via auto-translation).
If Japan’s equity meltdown is more about fund flows than fundamentals, bargain hunting looks plausible. The unwinding of the yen carry trade has cranked up volatility and triggered a chain reaction of selling, with inflation hedges under pressure on the idea that the Fed is behind the curve. Rising correlations between stocks have made diversification strategies pointless, encouraging a response of “sell everything”.
Takada and team told clients late last week that the Japan-led sell-off was “highly technical in nature”, and “probably not connected to some kind structural change in overseas conditions”.
Monday’s plunge had them doubting that view:
Generally speaking, it is recognized that market turmoil on the scale of the past three business days is unlikely to occur unless a tail event such as a war, pandemic, natural disaster, or financial crisis occurs. Of course, this may be a rare case in which this rule of thumb does not apply. However, we cannot completely rule out the possibility that the market is factoring in the occurrence of a black swan event that cannot be observed from the superficial data and information currently available. Although it is not our main scenario, we would like to pay close attention to the occurrence of historic political and economic turmoil in which Japan becomes the “epicenter” of some kind over the next month.
It’s a while since we’ve seen “there be dragons?” in mainstream analyst research. It’s not usually a sign that sentiment will be improving soon.
Further reading
— How the carry trade unwound the markets / the ‘undeserved scapegoat’ (FTAV, 2007)