Cash News
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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
A carry trade is all the financial markets clichés at once. It’s picking up coins in front of a steamroller en route by escalator to a crowded rooftop bar before they take away the punch bowl. It’s Wile E. Coyote’s reversion to the mean, gradually then suddenly, having changed his mind after the facts change.
Another cliché that fits is the one about crashes being a feature, not a bug. The excess returns possible from buying higher-yielding assets with low-interest-rate currencies survive in plain sight because of the risk that the trade will suddenly, violently reverse. How best to price the risk is a subject of endless debate.
The big story over the past week or two has been forced selling following the rapid unwind of G10 carry trades. And because markets are complex systems, indiscriminate sales of equities in thin summer markets got a bit mixed up with narratives of a slowing US labour market, a flat-footed Fed, the AI bubble, various geopolitical tensions, momentum trading strategies, crypto-bobbins, and the looting of a Shoe Zone in Hull.
Less than three days later, a majority of things are almost back to where they started, helped overnight by the Bank of Japan’s Deputy Governor Shinichi Uchida promising no hikes when markets are unstable . . .
. . .which seems to vindicate everyone (such as our Unhedged colleagues) who said the rout was more about fund flows than fundamentals. The big question therefore is whether those flows will come back.
The yen carry trade began to unwind last month as investors repriced the probability of G10 interest rate cuts. Expectations of where the Fed funds rate would be by end-December moved a whole percentage point lower, causing trouble for anyone shorting safe-haven currencies to buy dollar assets.
As a result, the FX market is unwinding the biggest short yen position recorded since 2007, according to SocGen analyst Olivier Korber:
The unwind began with yen speculative net shorts cut to 73,000 contracts from a peak of 184,000 contracts at the start of July — so even in thin summer liquidity the clean-up should be near to complete, Korber says in a note published today. (The Commodity Futures Trading Commission’s Commitments of Traders report, due tomorrow, will give a read on whether he’s right.)
The unwind has not been so quick for the Swiss franc, the other safe-haven currency commonly used to fund carry trades, SocGen notes. It’s a much smaller market than the yen though, so the ripple effect should be less pronounced:
Will carry trades resume as soon as the mess is cleaned out? Probably not, says Korber. He argues recent FX volatility is too much.
Rate differentials remain attractive. The average carry — as measured by the three highest-yielding G10 currencies minus the three lowest-yielding ones — has fallen only 0.1 to 0.15 percentage points from a peak in end-June above 3.8 per cent. By historical standards that’s very high:
. . .but the sudden spike in volatility has cost the yen and Swiss franc their safe-haven status, says Korber:
Looking at USD/JPY one-year realised volatility over the past 20 years, the rapid spot downside created the third or fourth biggest volatility spike of this period. Market moves testing the limits of risk models and involving considerable portfolio losses can only discourage JPY or CHF shorts, not to say that the options market skew still sees large upside risk in these currencies. Arguably, the carry trade is not going to involve selling the usual funding currencies any time soon.
So-called FX volatility carry — using options to harvest the difference between a currency pair’s implied and realised volatility — also looks too dangerous to contemplate. Erratic market moves have pushed higher the “realised volatility” side of the equation and suppressed the premiums on offer. Korber says month’s black-swan events ought to keep investors on the sidelines for a long time.
It’s sensible advice, but there’s no guarantee it will be followed. We’ve been here before. And if the popularity of carry trades proves anything, it’s the irresistible power of selective amnesia.
Further reading
— The yen’s short-smashing, carry-crunching Trump jump (FTAV)
— There’s no quick cure for a Japanese momentum trade hangover (FTAV)