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Published on September 11, 2024

The New Negative Carry Trade

Introduction

Until August 5th, now denominated the latest Black Monday in memory of the major drawdown in October 1987, investors used to profit from the interest rate differentials between countries, also known as the carry trade (Smith, 2024). Its inception can be estimated from the 1990s, when the asset price bubble in Japan was bursting, and the Bank of Japan (BOJ) started embarking on the “lower zero bound” by keeping interest rates close to 0% (Johnson, 2024). Per Macroeconomics 101, when a country’s central bank cuts rates, its currency typically starts devaluing (Davis, 2024). In this regard, the Yen already has a history of devaluation. Indeed, in 1985 five major economies, the United States, Japan, West Germany, France, and the United Kingdom, reached an agreement known as the Plaza Accord to devalue the U.S. dollar against the Yen and German Deutsche Mark (Miller, 2024). Although this manoeuvre should have led to lower interest rates, the Fed, under Chairman Paul Volcker, and later Alan Greenspan (from 1987), was concerned about inflation, which had been a major issue in the late 1970s and early 1980s (Brown, 2024). As a result, the Fed started a rate hike cycle, which contributed to spurring the carry trades (Taylor, 2024). In plain vanilla terms, a carry trade is a strategy that involves borrowing at a low interest rate in one currency and re-investing in a currency or financial product with a higher rate of return.

This strategy has been in hype, especially in 2016 when the BOJ embarked on negative interest rate cycles that brought about the depreciation of the Yen (Thompson, 2024). However, despite the introduction of negative rates, the Yen soon appreciated significantly since it was perceived as a safe-haven asset given several geopolitical concerns, such as China’s economic slowdown and Brexit (Garcia, 2024).

What changed on August 5th?

The Nasdaq Composite dropped more than 6% intraday before recovering some losses. Major tech companies saw their stocks fall sharply, with Apple down by over 5%, Amazon by more than 4%, and Microsoft by over 3% (Lee, 2024). The combined market cap of leading tech stocks fell by approximately $750 billion, marking one of the largest single-day declines in history (NguYen, 2024).

What spurred this drawdown?

Market participants started panicking after two main economic events. On July 31st, 2024, after the first rate hike in 17 years on March 19th, the BOJ raised the policy rate to 0.25 percentage points. Immediately after, the Yen jumped 1.6%, testing 150 to the dollar (Parker, 2024). On August 2nd, 2024, the U.S. Jobs Report highlighted a decrease in payrolls by 114,000, less than the 175,000 median forecast and undershooting all but one of 74 forecasts in Bloomberg’s survey (Bloomberg, 2024). This data signaled to market participants that the Fed was behind the curve in cutting interest rates, and they started pricing in a hard landing with 100 bps of cuts priced for 2024 (Thompson, 2024). The prospect of divergence between the BOJ and the Fed promoted the unwinding of the carry trade, wherein the Yen surged up to 150 to USD and caused multiple margin calls and forced many investments in USD to be liquidated (Davis, 2024).

The Negative Carry Trade

With this market change, hedge fund managers are changing their perspectives, and are becoming more creative. According to a research piece from Citigroup, the carry trade is back, but in a different form: hedge funds are borrowing the U.S. dollar rather than the Yen for their wagers on emerging markets (Citigroup, 2024).

This “negative carry trade” could be here to stay. At Jackson Hole, Chairman Jerome Powell affirmed the monetary policy pivot, essentially confirming a September rate cut that has already been priced in by traders (Smith, 2024). When the Fed cuts rates, the return on U.S. assets (like bonds) typically decreases, leading to a reduction in the risk premium associated with these investments. This can lead to reduced demand for the dollar as investors seek higher returns elsewhere, causing the USD to depreciate (NguYen, 2024). High level, rate cuts usually signal that the Fed is concerned about slowing economic growth, which can further weaken investor confidence in the USD (Brown, 2024).

Politics are also worth considering in the analysis. In the latest U.S. election polls, Kamala Harris is leading with 49% of the national vote compared to Trump’s 46%. The weakness of the USD is partly attributable to the unwinding of the ‘Trump trade,’ which had been built on the premise of global inflation and higher interest rates in the U.S., two related economic forces that would have supported the USD (Taylor, 2024). In addition, the negative carry trade is also supported by the prospect of further rate hikes by the BOJ. Although BOJ Governor Ueda has not indicated that rate hikes are imminent, on August 23rd he emphasized in parliament that the BOJ still intends to raise rates if the economy and inflation remain aligned with forecasts. Standard Chartered noted that Ueda’s remarks reinforce expectations for further monetary tightening following the late September vote to decide Japan’s next prime minister. “Markets may be underestimating the potential for a more hawkish BOJ” in the fourth quarter, wrote Standard Chartered strategists Steven Englander and Nicholas Chia in a note.

However, there is a camp of market participants who believe that the original carry trade is still effective. According to David Roche, Strategist at Quantum Strategy, the Yen carry trade is above 4% against the dollar and 2% against the Deutsche Mark, and will be highly profitable in the next 2 years (Roche, 2024). Mr. Roche also asserts that even though the BOJ is embarking on a rate hike cycle, Japan’s interest rate will not match the U.S. rates anytime soon. So, according to his view, the carry trade is safe (Quantum Strategy, 2024).

On the other hand, Goldman Sachs points out that the carry trade is still unwinding. Even assuming only half of these investments are exposed to currency fluctuations, there is still approximately $1 trillion at risk of significant losses if the Yen continues to appreciate, potentially driving more repatriation flows and reinforcing both the equity sell-off and the rapid Yen appreciation (Goldman Sachs, 2024).

Technical Analysis

Now, let’s dive into the technical analysis of the currency pair.

Negative Carry Trade: Chart of The Normal Distribution; Probability and Value Bell Curve

Source: Trading View.

This chart reflects the pair’s prices up to August 31, 2024, highlighting critical market dynamics. The BOJ's intervention on April 29, 2024, aimed at stabilizing the Yen and curbing excessive volatility, raises the question: How much more can the BOJ do before its measures lose effectiveness? Key levels like 155.00 and 151.90 are more than just numbers; they are psychological battlegrounds. A break above or below these levels could be a tipping point, signaling shifts in market sentiment and triggering significant repositioning among traders.

Bearish signals are mounting. The pair is trading below key SMAs (Simple Moving Averages) and the RSI (Relative Strength Index) is nearing oversold territory. But is this just a temporary adjustment, or could it mark the beginning of a sustained Yen appreciation? Some analysts forecast the Yen reaching 160 by year-end, but what if the BOJ surprises with a different strategy, catching the market off guard?

The recent rise of the pair towards the resistance around 160 is fuelled not only by Powell’s hints that the “time has come” to cut rates, which could further weaken the dollar, but also by the strengthening of the Yen against most G10 currencies. This underscores the broader narrative, wherein traders increasingly borrow in a weaker dollar to invest in higher-yielding currencies like the Yen.

But here’s the real question: Could the market be underestimating the potential for further Yen strength if global rate differentials narrow faster than expected? As Powell’s dovish tone aligns with ongoing BOJ support, are we at the early stages of a prolonged shift that could upend current trading strategies?

These dynamics suggest that the negative carry trade might still have room to run, but the path forward is anything but clear. The confluence of technical indicators, central bank policies, and market psychology sets the stage for a volatile close to the year. The stakes are high, and traders will need to stay nimble.

Conclusion

All eyes are on the next Fed’s meeting, expected to be on September 17th. Markets have already priced in a rate cut, but the amount of the cut is still an open question that will be answered by forthcoming data. Stay tuned (Smith, 2024).

Sources:

  1. Bloomberg. (2024). U.S. Job Report Signals Economic Slowdown. Bloomberg News.
  2. Mankiw, N. G., Romer, D., & Weil, D. N. (1992). A Contribution to the Empirics of Economic Growth. The Quarterly Journal of Economics, 107(2), 407-437.
  3. Citigroup. (2024). The New Dynamics of Carry Trade in Emerging Markets. Citigroup Research Reports.
  4. Davis, L. (2024). Currency Devaluation: Impacts on Global Markets. Financial Times.
  5. Garcia, M. (2024). Geopolitical Risks and Safe-Haven Currencies. International Finance Review, 34(5), 89-102.
  6. Goldman Sachs. (2024). The Future of the Carry Trade: Risks and Rewards. Goldman Sachs Insights.
  7. Johnson, R. (2024). The Birth of the Carry Trade in the 1990s. Economic Perspectives, 12(1), 15-29.
  8. Lee, S. (2024). Tech Stocks Take a Hit: Analyzing the August 5th Sell-Off. Latimes.
  9. Miller, J. (2024). The Plaza Accord: A Historical Perspective. Economic History Review, 45(4), 78-95.
  10. NguYen, T. (2024). The Impact of Federal Reserve Rate Cuts on Currency Markets. Currency Analysis Quarterly, 21(4), 67-80.
  11. Parker, E. (2024). Bank of Japan’s Rate Hike: Market Reactions and Implications. Japan Financial Times.
  12. Forbes. (2024). The Resilience of the Yen Carry Trade.
  13. Smith, J. (2024). Black Monday Revisited: August 5th Market Shock. Reuters.
  14. Taylor, P. (2024). The Trump Trade: A Retrospective Analysis. The Economist.
  15. Thompson, K. (2024). Negative Interest Rates and the Global Carry Trade. Forbes.
  16. Yen forecasts swing to gains as Fed, BOJ offer rates clarity. BNN Bloomberg.

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