How did a tiny Bank of Japan rate hike cause a massive global sell-off? 📉 The Yen carry trade is unraveling—are your investments safe?

The Yen carry trade, a financial strategy involving borrowing cheap yen to invest in U.S. momentum stocks, recently experienced a significant disruption. This strategy, heavily used by macro hedge funds, became increasingly popular when Japanese yields went negative, and the “FANG” stocks became the preferred investment. The trade’s popularity grew, contributing to a carry trade estimated between $20 to $30 trillion. However, on August 5, 2024, the Bank of Japan raised interest rates, ending years of ultra-low rates. This move caused the yen to appreciate sharply, leading to a significant selloff in Japanese and global markets. The appreciation of the yen and rising rates marked a reversal of the carry trade’s profitability, leading to widespread market disruptions. Despite some claims that 75% of these trades are closed, the market reaction suggests otherwise. The ongoing uncertainty surrounding the Yen carry trade and its impact on tech stocks raises concerns about future market stability.

The Historical Context and Growth of the Yen Carry Trade

The roots of the Yen carry trade can be traced back to the collapse of the Japanese stock market bubble in 1989. The subsequent decades of deflation and ultra-low interest rates in Japan created an environment where borrowing costs remained persistently low. This situation set the stage for the Yen carry trade to become a dominant strategy among macro hedge funds and other sophisticated investors.

As Japanese government bond yields went further into negative territory, and with the rise of high-performing technology stocks, particularly the “FANG” stocks (Facebook, Amazon, Netflix, and Google), the Yen carry trade grew in popularity. The combination of low borrowing costs and high returns in U.S. equities created a compelling opportunity for investors to capitalize on the spread between the two markets. This strategy became so widespread that it reached an estimated size of $20 to $30 trillion.

The Recent Market Disruption: August 5, 2024

The Yen carry trade has long been a stable, if somewhat under-the-radar, component of global financial markets. However, on August 5, 2024, this stability was shattered. The trigger for this disruption was a significant policy shift by the Bank of Japan (BOJ), driven by rising core inflation and wages in Japan. For the first time since 2008, the BOJ raised interest rates, bringing them into positive territory.

This rate hike came at a time when the U.S. Federal Reserve was projected to begin easing its monetary policy. The divergence in monetary policy between Japan and the U.S. led to a sharp appreciation of the Japanese yen, which surged by 14%—one of the largest jumps in decades. This sudden currency appreciation had far-reaching consequences, not only for Japanese markets but also for global investors engaged in the Yen carry trade.

Japanese stocks experienced their worst three-day selloff in at least seventy years, a reflection of the widespread impact of the Yen carry trade unwinding. The magnitude of the selloff underscored the enormous size and influence of the carry trade, suggesting that even a relatively modest rate hike by the BOJ—just 25 basis points—could trigger a significant market event. This reality casts doubt on narratives, such as those from JP Morgan, claiming that 75% of the Yen carry trades have been closed. The extent of the recent market turmoil indicates that the Yen carry trade remains a powerful, albeit opaque, force in global markets.

FXY Technical Analysis (Daily)

The chart for the Japanese Yen Trust CurrencyShares (FXY) in the daily time frame shows a significant shift in momentum recently. After a prolonged downtrend, the price action has turned bullish, breaking through key moving averages. The price has crossed above the 50-day and 200-day moving averages, which are now acting as potential support levels. The 50-day moving average is at 59.46, while the 200-day is at 61.38. The current price is above both, at 63.03, signaling a potential trend reversal.

Volume has seen a notable increase, particularly during the recent upward price movements, suggesting strong buying interest. The spike in volume confirms the strength of the recent breakout.

The Relative Strength IndexIn the world of technical analysis, the Relative Strength Index (RSI) stands as a cornerstone tool for traders seeking insights into market momentum. Developed by J. Welles Wilder ... More (RSI) is at 69.52, approaching the overbought zone (typically above 70). This indicates strong bullish momentum, but also suggests that the stock might be nearing an overbought condition, potentially leading to a short-term pullback.

The On-Balance VolumeThe On Balance Volume indicator (OBV) is a technical analysis tool used to measure the flow of money into and out of a security over a specified period of time. It is a cumulative ... More (OBV) shows a recent uptick, aligning with the price increase, which supports the bullish trend. However, it’s still below previous highs, indicating that the overall buying volume hasn’t reached its peak yet.

The Stochastic RSIIn the realm of technical analysis, the Stochastic RSI (StochRSI) emerges as a powerful tool for traders seeking to navigate market dynamics with precision. Developed by Tushar S. ... More is at 0.470, showing that it has recently crossed into the lower range from an overbought condition. This could indicate a cooling off period or a possible correction in the near term, especially if it crosses below 0.20.

The Chaikin OscillatorNamed after its creator Marc Chaikin, the Chaikin Oscillator stands as a formidable tool in the arsenal of technical analysts. This oscillator is designed to measure the accumulati... More is at 361,123, showing increasing money flow into the asset, further supporting the bullish case.

The MACDThe MACD indicator is essentially a momentum indicator that shows the relationship between two different moving averages of price. The MACD is the difference between the 12-period ... More Oscillator is in positive territory with the MACD line at 1.90 above the signal line at 1.47. The histogram is also positive at 0.43, indicating that the bullish momentum is currently strong.

Time-Frame Signals:
3 months: Buy – The recent breakout above the 50-day and 200-day moving averages, coupled with strong volume and positive momentum indicators, suggests a bullish trend in the medium term.
6 months: Hold – While the trend is currently bullish, the RSI nearing overbought conditions and the Stochastic RSI indicating a potential pullback suggest that it might be prudent to wait and see how the price action develops over the next few months before making further commitments.
12 months: Hold – Given the potential for a longer-term trend reversal, it’s advisable to maintain a cautious stance. The trend will need to establish itself more firmly before a longer-term buy signal is justified.

FXY Technical Analysis (Weekly)

The chart shows the weekly performance of the Japanese Yen Trust CurrencyShares (FXY) over the past year, reflecting a significant downtrend from around September 2023 to July 2024, followed by a sharp recovery in the last few weeks.

1-year time frame: The recent strong upward movement, breaking above the anchored VWAP from August 2023, indicates a potential shift in trend. The sharp increase in volume suggests strong buying interest, which could lead to a continued recovery in the near term. However, the on-balance volume (OBV) remains negative, indicating that more sellers have been involved over the past year. This mixed signal suggests a cautious approach, with the potential for continued volatility.

2-year time frame: The broader trend over the last two years shows a peak followed by a prolonged decline, with the recent upward movement still within the context of a larger downtrend. This could be interpreted as a bear market rally unless the price can sustain above key resistance levels, such as the 65-66 range. A break above this area with sustained volume would be necessary to confirm a longer-term reversal.

3-year time frame: Over three years, the chart shows a cycle with a previous uptrend that peaked in late 2022, followed by a significant downtrend. The recent recovery might be an early signal of the end of this downtrend cycle, but confirmation would require a break above major resistance levels and a sustained positive shift in OBV.

Past performance is not an indication of future results. This article should not be considered as investment advice. Always conduct your own research and consider consulting with a financial advisor before making any investment decisions. 🧡

The Impact on U.S. Technology Stocks

One of the most affected sectors by the unwinding of the Yen carry trade has been U.S. technology stocks, particularly those categorized as momentum trades. These stocks, which had benefited from the cheap funding provided by the Yen carry trade, faced sharp declines as their funding source became more expensive. The “Magnificent Seven” index, a group of leading tech stocks, dropped by 16% from 310 to 260 in just four weeks. Smaller momentum stocks, such as Super Micro, experienced even more significant losses, with an 18% decline in a single week.

The selloff in these stocks can be largely attributed to margin calls triggered by the Yen carry trade unwinding. As the yen appreciated and borrowing costs increased, investors who had leveraged their positions through the carry trade were forced to sell assets to meet their obligations. This selling pressure exacerbated the decline in tech stocks, creating a feedback loop that further intensified the market downturn.

Insights

• The Yen carry trade’s collapse highlights the risks of over-leveraging in financial markets.
• Japanese monetary policy changes have global repercussions, especially for U.S. tech stocks.
• Market narratives may not always reflect the actual risks, as seen with JP Morgan’s possibly misleading statements.

The Essence (80/20)

The core issue revolves around the Yen carry trade, a strategy of borrowing cheap yen to invest in high-yield assets, particularly U.S. momentum stocks. The trade became extraordinarily large due to Japan’s ultra-low interest rates. However, when the Bank of Japan raised rates on August 5, 2024, the yen appreciated significantly, causing a sharp selloff in Japanese and global markets. The market reaction suggests that the size and influence of the Yen carry trade are far larger than many believed, despite claims that the majority of these trades have been closed. This event underscores the interconnectedness of global financial systems and the potential for sudden policy shifts to cause widespread market disruptions.

The Guerilla Stock Trading Action Plan

1. Monitor Japanese Monetary Policy: Investors should closely follow changes in Japan’s interest rates as these can have global implications.
2. Reduce Leverage Exposure: Given the risks highlighted by the Yen carry trade, reducing exposure to highly leveraged positions may help mitigate potential losses.
3. Diversify Investments: To safeguard against similar market shocks, diversify investments across different asset classes and geographies.
4. Reevaluate Tech Stocks: Investors should reassess positions in tech stocks that were previously boosted by the Yen carry trade, as these may now face headwinds.

Blind Spot

The potential spillover effects of the Yen carry trade unwind on emerging markets and other asset classes may be underestimated. If the trade unravels further, it could trigger a broader financial contagion beyond what is currently anticipated.

The Uncertain Future of the Yen Carry Trade

The recent disruption in the Yen carry trade raises important questions about its future. While some traders may see the current market conditions as an opportunity to buy sold-off assets, many others are adopting a more cautious approach. The uncertainty surrounding the Bank of Japan’s future monetary policy moves, particularly in the context of rising inflation, has created a climate of apprehension among investors.

The potential for further unwinding of the Yen carry trade remains a significant risk factor for global markets. As the BOJ continues to navigate the challenges of inflation and economic stability, the repercussions of its policy decisions will likely be felt far beyond Japan’s borders. For now, the Yen carry trade serves as a reminder of the interconnectedness of global financial markets and the potential for seemingly abstract strategies to have profound and far-reaching effects.