Today, the U.S. stock market opened down over 4% from its previous close, following a 2.6% drop to close out last week. This significant two-day decline has understandably caused concern among many investors.
Please rest assured that our investment management team at A Smarter Way to Invest is closely monitoring the developments in market conditions, and we are prepared to make necessary adjustments to our models and allocations in response to these changing conditions if needed.
Additionally, at A Smarter Way to Invest we utilize proprietary market signals to manage risk in our Dynamic Allocations. These allocations were already positioned with a reduced risk weighting before the sell-off began last week.
What is causing this sudden increased volatility in the market?
Some financial commentators are pointing to recession worries and a decline in the manufacturing activity index as the catalysts for the recent sell-off. While the decline in economic activity may be putting overall downward pressure on equity markets, the sudden decline in equities appears to be driven primarily by what is known as the “Yen/Carry Trade”.
What is the Yen/Carry Trade?
A “carry trade” is a strategy where an investor borrows money in a particular currency whose home country has low interest rates and subsequently invests that money in a currency whose country has a higher interest rate. The interest rate differential between the two currencies provides the investors with an expected return, similar to the concept of “arbitrage”, as the returns earned with the high-interest currency exceed the cost of borrowing from the low-interest currency. The primary risks with this type of strategy are exchange rate risk between the two currencies, as well as interest rate risk that can indirectly drive the currency valuations relative to each other. As the value of the currency invested in declines relative to the currency of the borrowed funds, the less return is earned by the investor, and may result in significant losses if it declines enough. Additionally, if the domestic interest rate declines in the currency/country invested in (or alternatively increases in the currency/country borrowed from), investors will experience lower return arbitrage or even losses if the change is large enough. Carry trades are often highly speculative and frequently use a significant amount of leverage in order to amplify returns. However, this leverage will also exacerbate and amplify any losses.
Interest rates in Japan have been extremely low for quite some time, and investors have been borrowing money in Japanese Yen, converting that money to U.S. Dollars, and investing in U.S. markets to earn a higher return than their cost of borrowing. This has become more prevalent as of late, with the risk-free rate on U.S. Treasuries rising substantially over the past couple years. For example, if an investor borrowed the Japanese Yen (JPY) at a 1.0% interest rate, converted it to U.S. Dollars (USD) at an exchange rate of 161 JPY per 1 USD, and invested in USD at a 5.0% interest rate, they would expect to make a 4.0% return, assuming they could exchange dollars for yen at the same rate of 161 JPY per 1 USD and repay their debt in yen. However, if the exchange rate moved against the investor and they could only exchange dollars for yen at a rate of say, 142 JPY per 1 USD, they would incur a net loss due to unfavorable exchange rates and a loss on currency exchange (approximately 11.8% currency loss) in excess of the interest rate differential for 4.0%, resulting in a net -7.8% loss overall. This loss would be further compounded if the borrowing rate in Japan were to rise above 1.0%. An illustration of the hypothetical scenario in dollars is below:
The use of leverage magnifies both potential gains and potential losses, thereby increasing volatility of these carry trades.
Recent developments in the Yen/Carry Trade
The Japanese Yen has acted as a funding currency for this type of carry trade for quite some time, as interest rates in Japan have been extremely low and at near-zero levels for years. However, as of late, the trade has been unwinding as the yen has strengthened relative to the dollar over the last few weeks. On July 1st, the USD/JPY exchange rate was 161.14. By July 31st it had dropped to 150.31, and today, August 5th, it is approximately 142. This morning, the Bank of Japan’s (BOJ) June minutes were released, indicating a more hawkish view of Japan’s economy than previously expected, as two of their nine board members called for an early interest rate increase prior to the rate hike in July that increased their rate target to 0.25% (the highest since 2008) [1]. Some believe this points to further rate hikes ahead, raising fears of heightened interest rate and exchange rate risk for the Japanese Yen, and weak US labor data released last Friday has further reinforced a weaker USD relative to the JPY. This sharp appreciation of the yen and increased currency risks has added pressure on investors to unwind their yen carry trades. The unwinding of these trades can have significant spillover effects due to many traders and speculators all exiting US markets at once in order to closer out (or “cover”) their trades, as well as having to possibly free up other assets to maintain liquidity. Further, with the use of leverage exacerbating the risks of losses, volatility has spread across numerous asset classes as various funds and leveraged traders seek to de-risk and deleverage their overall balance sheets. The impact on US markets has been significant, with several US equity market indices experiencing large declines last Friday and opening this morning well below the previous close levels.
The Bottom Line
While the recent sell-off from Friday and today has understandably caused concern for investors, it appears to be driven more by short-term volatility from currency speculators than a sudden decline in fundamental and economic circumstances, though we still maintain a cautious stance with regards to our own domestic economic environment and our Dynamic Allocations have been in a reduced risk exposure position prior to these recent market developments. We are likely to see continued volatility in the near-term until these trades are unwound and the flow of funds between capital markets stabilize. As always, we are continuing to monitor the situation and market conditions, and we are prepared to adjust our models and allocations to further reduce risk exposure as necessary. If you have any questions or concerns, please do not hesitate to reach out.
