Last Monday, global financial markets experienced a significant shake-up as the unwinding of the Japanese yen carry trade sent shockwaves across equities, currencies, and digital assets. The S&P Global Broad Market Index, which tracks the performance of over 14,000 stocks worldwide, retreated by 3.3%—its most severe trading day in over two years. The Tokyo Stock Price Index (TOPIX) suffered a 20% drop in its largest three-day plunge in history. Meanwhile, the Bloomberg Galaxy Crypto Index plummeted by as much as 17.5%.

As someone who has weathered numerous market storms over the decades, I believe it’s essential to delve into the underlying causes of these movements and extract the valuable lessons they hold for investors.

Understanding the Japanese Yen Carry Trade

Carry trades have been a popular strategy among investors, particularly in a low-interest-rate environment like that of Japan. The concept is straightforward: investors borrow in a currency with low-interest rates—such as the Japanese yen or Swiss franc—and invest the proceeds in higher-yielding assets elsewhere, often in currencies like the U.S. dollar or emerging market currencies. This strategy has proven to be immensely profitable over the years, particularly given the Bank of Japan’s (BOJ) longstanding zero or near-zero interest rate policy.

However, the recent rate hike by the BOJ, aimed at addressing inflationary pressures, has thrown a wrench into these trades. The result? A rapid appreciation of the yen against the U.S. dollar, which in turn has led to a significant unwinding of yen-funded carry trades. This phenomenon has reverberated across global markets, causing substantial volatility and raising concerns about the broader implications for the financial system.

The Yen’s Rise and Its Historical Parallels

The yen’s recent appreciation is not an isolated event but rather echoes past financial crises. Historical precedents can provide valuable context for understanding the current situation. For instance, during the 1998 Long-Term Capital Management (LTCM) hedge fund collapse, the yen appreciated by 20% from its low, contributing to a global market selloff. Similarly, during the 2007 subprime mortgage crisis, the yen again surged as investors unwound carry trades, seeking refuge in safer assets.

As of early August 2024, the yen had already appreciated by over 10% against the U.S. dollar. This sharp rise in the yen has put significant pressure on Japan’s export-oriented economy. A stronger yen makes Japanese goods more expensive on the global market, reducing their competitiveness and potentially leading to a slowdown in economic growth. The impact on the Japanese stock market has been profound, with the TOPIX experiencing its worst decline in decades.

The Bank of Japan’s Response and Market Implications

In response to the market turmoil, the BOJ quickly walked back its hawkish stance. Deputy Governor Shinichi Uchida made a public statement pledging to refrain from further rate hikes amid the ongoing market instability. This move is expected to provide some short-term relief to the markets, but the broader implications of the yen’s rebound and the unwinding of carry trades will likely continue to influence global financial markets for the foreseeable future.

It is crucial to recognize that the unwinding of carry trades is not yet complete. According to a report dated August 9 by JPMorgan, the unwind is only about halfway done. This suggests that we may see further volatility in the markets as investors continue to unwind their positions. Additionally, financial markets are currently pricing in the possibility of multiple rate cuts by the Federal Reserve later this year. If this scenario unfolds, it could further exacerbate the carry trade unwind, leading to even more significant market disruptions.

The Broader Impact on Global Financial Markets

The unwinding of the yen carry trade has had a ripple effect across global financial markets, affecting everything from equities to digital assets. The S&P Global Broad Market Index’s 3.3% decline is a testament to the widespread impact of these events. This index, which tracks over 14,000 stocks from around the world, serves as a broad gauge of global equity performance. The sharp decline underscores the interconnectedness of global financial markets and how a significant event in one region can quickly spread to others.

Emerging markets have been particularly hard-hit by the unwinding of the carry trade. Many emerging market currencies, such as the Turkish lira and the South African rand, have experienced sharp declines as investors repatriate funds back to safer assets. This has led to increased volatility in emerging market equities and bonds, raising concerns about the stability of these markets.

Bitcoin and Gold: A Tale of Two Assets

As global equities tumbled, Bitcoin’s behavior during the selloff sparked significant interest. The world’s largest digital asset dropped as much as 17% last Monday—briefly falling below $50,000 for the first time since February 2024—before recovering some of its losses, ending the day down 8%. In contrast, gold, which has traditionally been viewed as a safe-haven asset, fell by just over 1% on the same day.

This contrasting performance between Bitcoin and gold highlights a crucial point in the ongoing debate about Bitcoin’s role as “digital gold.” While Bitcoin is often touted as a store of value similar to gold, its performance during times of market stress suggests otherwise. Gold has a long history of maintaining its value during periods of financial turmoil, whereas Bitcoin has shown to be more volatile and behaves more like a risk-on asset.

Citi analyst David Glass recently commented on this dynamic, stating, “Despite both gold and Bitcoin being limited supply, zero-coupon instruments, [Bitcoin] does not exhibit gold’s ‘store of value’ properties.” Our analysis adds further context to this statement, showing that Bitcoin has historically behaved more like a risk-on asset than a safe haven.

Over the past decade, during the 10 worst months for the S&P 500, Bitcoin fell by an average of 6.4%, while gold remained slightly positive with an average return of 0.8%. Conversely, during the best 10 months for the S&P 500, Bitcoin surged an eye-popping 22.4% on average, significantly outpacing gold’s 1.5% gain. This data suggests that while Bitcoin may offer higher potential returns during market rallies, it also comes with greater risk during downturns.

The Yen Carry Trade and the Future of Financial Markets

The recent market turmoil serves as a stark reminder of the risks inherent in carry trades and the broader implications of central bank policies. The Bank of Japan’s recent rate hike, while aimed at controlling inflation, has had far-reaching consequences that have reverberated across global markets. As investors navigate this uncertain environment, it is crucial to remain vigilant and consider the potential risks and rewards of different investment strategies.

For conservative investors, a 10% weighting in gold and gold mining stocks remains a prudent approach to hedge against market volatility. For those with a higher risk tolerance or a longer time horizon, Bitcoin and other digital assets may offer attractive opportunities, albeit with higher potential risks.

Lessons for Investors

The unwinding of the yen carry trade and the subsequent market turmoil underscore the importance of understanding the broader macroeconomic environment and the potential impact of central bank policies on global financial markets. Investors should be cautious about overexposing themselves to riskier assets, especially in the current environment where the unwinding of carry trades is still ongoing.

Diversification remains a key strategy for managing risk. By spreading investments across different asset classes, including equities, bonds, gold, and digital assets, investors can better navigate periods of market volatility. Additionally, staying informed about central bank policies and global economic trends is crucial for making informed investment decisions.

As we look ahead, the global financial markets will likely continue to be influenced by the actions of central banks, particularly the Federal Reserve and the Bank of Japan. The potential for further rate hikes or cuts, along with the ongoing unwinding of carry trades, will be key factors to watch in the coming months. Investors should remain cautious and consider the potential risks and rewards of their investment strategies in light of these developments.

In conclusion, the recent events surrounding the yen carry trade unwind serve as a reminder of the interconnectedness of global financial markets and the importance of understanding the broader macroeconomic environment. By staying informed and adopting a diversified investment approach, investors can better navigate the challenges and opportunities that lie ahead.

photo source: Google

By: Montel Kamau

Serrari Financial Analyst

13th August, 2024