Carry Trade Shocks Still Going On

Many economists, financial experts, and pundits chalked up the market retreats on Monday to the July jobs market data that came out on Friday. By Tuesday, they were saying it was an overreaction.

“In our view, the sharp sell-off in risk assets was overdone relative to the current health of the US economy, which is not on the precipice of a recession,” wrote Nationwide Chief Economist Kathy Bostjancic on Tuesday in emailed remarks. “Activity in the labor market and the economy overall is moderating as the Fed has held interest rates high; albeit the slowdown is a bit faster than we and likely Fed officials forecast. This raises the likelihood that the Fed reduces the fed funds rate by 75 – 100 bps by year-end to help support a soft landing – previously we looked for 50bps of rate cuts.”

That may be true, but many people have ignored a major global financial issue: the carry trade and a Bank of Japan interest rate hike send many investors scrambling to cover positions.

The carry trade is the practice of borrowing money in a low-interest-rate market and investing it in a higher-rate market. It’s like financial arbitrage, profiting off the difference in conditions between two markets.

Japan has been one of the main markets in the carry trade because of its long-term low rates in the face of slow growth. However, the value of the Japanese yen had been sliding against the U.S. dollar, so the Bank of Japan raised interest rates to 0.25% at the end of July from the previous 0% to 0.1% range. According to ABC News, the BOJ and the country are worried about the cost of imports, particularly oil.

One impact was to shake up the carry trade as investors had to cover positions.

“The reality is that markets move because of flows of capital and the amount of capital aimed at places that could provide return,” Ian Toner, chief investment officer of Verus, told GlobeSt.com. Like foreign exchange investing, trades often work on thin differences between markets. When rates rose by 15 basis points in Japan, it had the potential to make many investors scramble to cover open positions, similar to margin calls on equities.

As former Federal Reserve Chair William McChesney Martin Jr. said decades ago, it was the central bank’s job “to take away the punch bowl just as the party gets going.”

“This is a different punchbowl,” Toner says. “The people who control this punchbowl is the Bank of Japan. It’s unlikely to be a big effect and unlikely to be immediately impactful, but it represents a removal of liquidity from the market.” And that ultimately affects all markets, including CRE.

The perturbations are likely to continue for a while. “We expect the sell-off to continue for maybe a few more days as usually these… trades are pretty large,” Zhe Shen, head of diversifying strategies at TIFF Investment Management, told Reuters. “People said ‘Wait, we’re losing too much money from unwinding. Let’s just hold and we’ll unwind some more tomorrow.”