Carried away
Written on 2024-08-09, first published on 2024-08-13
Markets in focus
The USD/JPY pair experienced a sharp decline, falling over 12% from a recent peak of 162 to a trough of 143 within a few weeks. This move significantly impacted global financial markets. Though such rapid appreciation of the Japanese yen is notable, it is not unprecedented in the historical context.
The Nikkei 225 index plummeted by more than 28% from its recent high above 42,000, momentarily erasing all gains for the year before rebounding sharply from crucial support just above the 30,000 mark.
After prolonged stagnation, the U.S. Treasury yield curve has begun to normalize and resolve its inversion, reflecting market anticipation of impending Federal Reserve rate cuts.
The EUR/USD has been moving in a descending channel for nearly two decades. Currently, it is consolidating within a tight symmetrical triangle, aligning resistance with that of the descending channel. A breakout to the upside could markedly strengthen the euro against the U.S. dollar.
Our market views
As early as April, we issued a cautionary piece on a seismic shift due to the Bank of Japan (BoJ)'s decision to normalize interest rates. We anticipated that this policy shift would increase Japanese bond yields and strengthen the Japanese yen, triggering a significant unwinding of the massive "carry trade" built over the years. Here's a simplified recap: the Japanese yen became a preferred funding currency over the past decade, due to Japan’s ultra-low interest rates. Investors would borrow yen to invest in higher-yielding assets, such as U.S. equities, particularly the popular tech stocks. This strategy relies on two conditions: a stable yen and substantial interest rate differentials between the U.S. and Japan.
However, this strategy is inherently reflexive. A thriving U.S. economy spurred rises in the stock market, leading the Fed to increase interest rates. This widened the rate differential and strengthened the U.S. dollar, initially benefiting the carry trade. As the dollar appreciated, it enhanced the return on U.S.-denominated assets, drawing more foreign capital into the U.S. This influx of investment further boosted the equity market and the broader economy, creating a positive feedback loop: a rising stock market increased demand for the dollar, which, in turn, attracted more foreign investment into the stock market.
Yet, reflexivity works both ways. When the Fed initiated aggressive tightening, signs of a U.S. economic slowdown emerged, along with fears of a looming recession. These developments shifted market expectations toward imminent rate cuts by the Fed. Such expectations have led the U.S. Treasury yield curve to begin a bull-steepening phase after more than two years of inversion, with short-term rates falling more sharply than long-term rates, reflecting the market's anticipation of easing monetary policy.
The situation was exacerbated when the BoJ raised interest rates again, further narrowing the rate differential and strengthening the yen dramatically. This confluence of factors—higher borrowing costs, a stronger yen, and tumbling foreign assets—precipitated a rapid unwinding of carry trades. This unwinding intensified market volatility, with impacts so severe that Japan's domestic market suffered its most significant losses since the infamous 1987 Black Monday.
This pattern of reflexivity extends well beyond the yen carry trade. The strong U.S. dollar and robust equity market have historically attracted steady foreign investment, creating a self-reinforcing cycle of demand for dollars and outperformance of U.S. assets. However, emerging signs of economic slowdown, increasing unemployment, and equity market fluctuations suggest a potential shift. For the first time in years, we might see foreign capital retreating from the U.S., initiating a feedback loop reminiscent of the yen carry trade scenario.
The Federal Reserve now finds itself between a rock and a hard place: whether to cut interest rates early, potentially narrowing rate differentials too much and weakening the dollar, or to cut them late, risking a deeper recession and further declines in asset prices. Either scenario could incentivize a reversal of foreign capital flows.
On platforms like X (formerly Twitter), we've noted a marked increase in discussions about the "carry trade," which seems to echo a common hindsight bias prevalent in financial markets. However, our experience suggests that when market sentiment grew overwhelmingly one-sided, the real opportunities—or risks—tend to emerge elsewhere. It's also a reminder not to get carried away by the echo chamber of popular sentiment, as the underlying market dynamics often unfold off the mainstream radar.
Particularly vulnerable in this macro environment is the USD/EUR exchange rate. As the largest source of foreign direct investment in the U.S., European capital has been drawn by higher yields and dollar strength. We are closely monitoring for signs of a potential rapid strengthening of the euro due to capital outflow from the U.S. and the repatriation by the European investors. Once such a reflexive loop starts, it could have profound implications for the global financial markets.
How do we express our views?
We consider expressing our views via the following hypothetical trades1:
Case study 1: Long EUR/USD Futures
We would consider taking a long position in the EUR/USD futures (6EU4) at the current price of 1.093, with a stop-loss below 1.077, a hypothetical maximum loss of 1.093 – 1.077 = 0.016 points. Looking at Figure 4, if the breakout from the descending channel is confirmed, the EUR/USD rate has the potential to reach 1.40, resulting in 1.40 – 1.093 = 0.307 points. Each EUR/USD futures contract represents 125,000 EUR, and each point move is 125,000 USD. E-mini and Micro EUR/USD futures contracts are also available at ½ and 1/10 of the standard size.
Case study 2: Long U.S. Treasury Yield Steepeners
We would consider taking a long position in the U.S. treasury yield 5y30y steepener, by simultaneously selling one 5-year yield futures contract (5YYQ4) at 3.80 and buying one 30-year yield futures contract (30YQ4) at 4.26, effectively buying the yield spread at 4.26 – 3.80 = 0.46. We will have a stop-loss below 0, resulting in a hypothetical maximum loss of 0.46 points. Looking at Figure 3, if the yield curve continues to steepen, the 5y30y yield spread has the potential to reach 1.2, resulting in 1.2 – 0.46 = 0.74 points. Each point move in the 5-year yield futures and 30-year yield futures contracts, as well as the yield spread, is 1000 USD.
Original link here.
EXAMPLES CITED ABOVE ARE FOR ILLUSTRATION ONLY AND SHALL NOT BE CONSTRUED AS INVESTMENT RECOMMENDATIONS OR ADVICE. THEY SERVE AS AN INTEGRAL PART OF A CASE STUDY TO DEMONSTRATE FUNDAMENTAL CONCEPTS IN RISK MANAGEMENT UNDER GIVEN MARKET SCENARIOS. PLEASE REFER TO FULL DISCLAIMERS AT THE END OF THE COMMENTARY.
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