The Big Picture

Briefing.com Summary:

*The yen's 40-year low increases the risk of another carry-trade unwind that could trigger sharp, short-term volatility in global equity markets.

*Japanese policy action to support the yen could spark forced deleveraging as investors unwind yen-funded carry-trade positions.

*A carry-trade unwind is more likely to create a temporary market disruption than a systemic financial crisis, based on the August 2024 experience.

Kenny Chesney tells us in his country song "Don't Blink" that 100 years goes by faster than you think. With your author nearly midway through his fifth decade of life, those words ring truer each year.

Some experiences feel like a long time ago. Most, though, feel like they happened only yesterday. Going back 40 years isn't much of a stretch. It isn't even half a blink.

Financial markets have recently taken us back to 1986--the last time the New York Mets won the World Series and the last time the Japanese yen was this weak against the dollar.

That milestone isn't just a historical curiosity. It raises the market risk of another yen carry-trade unwind similar to the one that briefly rattled global markets in August 2024.

A Tourist Trap?

A weaker currency has its benefits. It boosts the earnings of Japanese multinationals generating revenue abroad in U.S. dollars and makes exporters more price-competitive internationally.

For Japan itself, a weaker currency is a boon for tourism, and it has also helped Japan emerge from a longstanding deflation environment.

For investors and speculators, the weaker yen has been a popular funding currency for carry trades, whereby investors borrow yen at low interest rates and invest the proceeds in higher-yielding currencies or assets, aiming to profit from the spread.

The U.S. has been a popular destination for carry-trade "tourists" thanks to its highly liquid markets, higher interest rates, and high returns for stocks (the S&P 500 is on pace for a fourth consecutive year of double-digit returns). 

Those tourists had a painful experience in August 2024. First, the Bank of Japan surprised everyone with a rate hike on July 31, and then the U.S. released a weak employment report on August 2 that fomented recession worries. Investors suddenly anticipated a widening policy divergence, with the Bank of Japan tightening while the Federal Reserve appeared poised to ease policy.

Sure enough, the yen appreciated sharply against the dollar with short-covering activity in play alongside an unwinding of the suddenly less attractive carry-trade positions, a portion of which were presumably juiced with added leverage.

In the blink of an eye, the yen went from 152.78 against the dollar on July 30 to 141.69 on August 5. Over the same period, the CBOE Volatility Index went from 17.69 to as high as 65.73. The fallout in global equity markets was pronounced.

Between July 30 and August 5, the S&P 500 declined as much as 5.8%, the STOXX Europe 600 dropped as much as 6.7%, and Japan's Nikkei plummeted 19.1%, punctuated by a 12.4% decline on August 5 that marked the largest single-day point loss in its history.

The speed and magnitude of those moves illustrated just how quickly a carry-trade unwind can spread across global financial markets.

Briefing.com Analyst Insight

The unwinding of yen-funded carry trades spilled quickly into global equity markets, triggering a sell-first-ask-questions-later response fueled by fears of forced liquidation.

We aren't revisiting this situation now to be fearmongers. On the contrary, we are highlighting it as a market risk, knowing that:

1. The yen is hovering at its weakest level against the dollar in 40 years.
2. Japan's finance minister has made it known that Japan stands ready to take "decisive steps" to support the currency if needed.
3. The Bank of Japan isn't expected to raise rates at its July policy meeting, making a surprise hike all the more impactful for the yen, and
4. The U.S. dollar continues to strengthen with inflation concerns pushing up interest rates in the U.S., which is exerting even more pressure on the yen that threatens to drive up inflation in Japan and to invite some more aggressive policy action from the Bank of Japan.

In brief, the incentive for Japanese policymakers to act is increasing. Whether that comes through currency intervention, an unexpected BOJ rate hike, or both, the result could be another rapid unwinding of yen-funded carry trades.

Such a move could trigger sharp, short-lived losses. The good news is that it appears more likely to be a market risk than a systemic risk, assuming there isn't some unforeseen exposure to broadly leveraged positions.

The distinction matters. Systemic risks threaten the functioning of the financial system itself and often have lasting economic consequences. Market risks, while painful, are typically driven by positioning and forced liquidations that eventually run their course. That was the case in August 2024.

The S&P 500 and STOXX Europe 600 recovered the entirety of the losses noted above approximately two weeks later. It took the Nikkei a little over a month. If you blinked, you might have missed that.

Don't blink now, though. The ingredients for another carry-trade unwind are beginning to fall into place, and if August 2024 taught investors anything, it's that these episodes can unfold in the blink of an eye.

--Patrick J. O'Hare, Briefing.com

(Editor's Note: The next installment of The Big Picture will be published the week of August 3)