The Japanese yen still poses 'a very big risk' to global markets. Here's why.

By Vivien Lou Chen

The yen carry trade is still alive, setting the stage for the possibility of a further unwind that may rattle U.S. stocks

There's one big factor behind early August's scare in the U.S. stock market which hasn't gone away and has little to do with a U.S. economic slowdown. It's the popular currency approach known as the carry trade.A month ago, the carry trade was blamed in part for a 12.4% plunge in Japan's Nikkei index and a cascading global stock-market selloff as investors rushed to exit from the strategy. The Dow Jones Industrial Average DJIA and S&P 500 SPX finished on Aug. 5 with their worst performances since Sept. 13, 2022, with the former plunging 1,033.99 points or 2.6%.

At the heart of investors' concerns is the fear that much of the U.S. stock rally seen in recent years was the result of easy borrowing via carry trades. The carry trade is a strategy based on borrowing at a low interest rate and using the proceeds to buy higher-yielding currencies or assets. With the Bank of Japan maintaining ultralow interest rates for years, investors loaded up on stocks and other assets from other countries via trades funded by the Japanese yen.

See: Blame it on the yen? 'Epic leverage' in carry trade 'beyond wildest market dreams'

Recent data suggests new carry trades have been put back on, with leveraged hedge funds increasing their short positions in yen futures, according to Ben Emons, chief investment officer and founder of Fed Watch Advisors in Washington.

Meanwhile, the yen has been appreciating, giving way to the view that the carry trade has room to unwind again. The Japanese currency, a typically low-yielding vehicle used to invest in higher-yielding alternatives, jumped more than 1% against the greenback on Wednesday and was trading around 143.42 per dollar (USDJPY) on Thursday - one of its strongest levels of the year.

Read: Markets quickly recovered from the early August meltdown - but investors may not be so lucky next timeAdding to the yen's strength are expectations that the Bank of Japan is certain to raise interest rates again, after having already lifted borrowing costs in July from around zero - a move which could reverberate around the world. Currency moves are often driven to a large degree by what's known as interest-rate differentials, or the difference in interest-rate policies around the world. With rates in the process of rising in Japan, the Federal Reserve is set to deliver its first interest-rate cut on Sept. 18 - leading to a drop in Treasury yields and the greenback, as measured by the U.S. Dollar Index DXY, since June and July.

"For all the good a modest and steady Fed rate cut profile might be for riskier assets, the BOJ may blow all of this out of the water should its rate hikes create enormous carry-trade unwinding," he wrote. It's not often that a foreign-exchange development has broader implications for U.S. stocks, and one has to look as far back as the 1997 Asian financial crisis to find a relevant comparison, said Tom Nakamura, a currency strategist and co-head of fixed income at AGF Investments in Toronto, whose parent company AGF Management Ltd. managed roughly $36.5 billion (CAD $49.3 billion) in assets as of July 31. The U.K. sovereign-debt crisis of 2022, triggered by a loss of credibility in the government's ability to manage its budget, sent the pound to all-time lows at the time and led to soaring yields in the region, but still managed to remain somewhat contained and wasn't "quite as acute," Nakamura said via phone on Thursday.Further unwinding of the yen carry trade is "still a very big cross-market risk, and investors are having some concern about what the Bank of Japan might do over the next year or two," Nakamura said. Whether the next market shake-up is triggered by a U.S. economic slowdown or central-bank decisions from abroad, "volatility is still pretty elevated and, in some cases, higher than what we saw in early August," the strategist said. "Some of that is going to be about carry-trade unwind, some of it is going to be about concerns ahead of the Nov. 5 presidential election, and, more recently, some of it is about concerns over economic weakness that may be steeper than what was expected."Emons of Fed Watch Advisors describes the carry trade as "the oldest trade on the street," and one which comes in "all shapes and sizes." This can include using U.S. dollars instead of the yen to borrow and to place wagers on emerging markets. Or it can be reflected in the Canadian dollar versus the yen, according to Emons.

Related: Mexican peso falls below key level. How a strong currency turned weak in a hurry.The carry trade "will continue to morph in shapes and sizes" because of its potential to spark cross-border rotation, Emons said on Thursday, noting that leveraged short positions in the yen have increased, while short positions in the Swiss franc, the euro, and the Canadian dollar have decreased. "The yen carry trade remains large, alive and seems to be increasing even though the BOJ signaled a next hike may be coming in October."On Thursday, U.S. stocks finished mostly lower as the Dow Jones Industrial Average fell 219.22 points and the S&P 500 had its third straight daily decline. Weighing on investor sentiment were signs of a slowing labor market, with the ADP employment report revealing businesses added just 99,000 jobs in August. But also lurking in the backdrop were worries about the yen."You're seeing the beginning of how sensitive markets have become to the carry trade and what it would take to unwind it," said AGF's Nakamura. Though a further unwind of the trade could turn into a "potentially big event," he said his view is that the carry trade is "still an attractive strategy overall. The fact that markets have recognized this risk helps to moderate the impact; the worst unwinds are unanticipated." The strategist regards 140 as a key level to watch on the yen versus the dollar. He added that a gradual strengthening of the Japanese currency to the 130-135 range should be manageable. But if it occurs in the next month or two, "that can spell trouble."

-Vivien Lou Chen

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09-05-24 1609ET

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