Unwinding the Carry Trade
Markets continue to reverse the extreme reaction to the unwinding carry trade. More unwind of the carry trade will occur, but we think the worst is over. Domestically, the Fed has signaled that more weakness would be needed to make a 50-basis point reduction in policy necessary. But we expect solid growth to continue. So, this round of fireworks appears to be over, as we now see it.
The plunge in global markets as investors unwound the carry trade reflected many investors trying to get out at the same time. Investors who borrowed very cheaply in yen could take those proceeds and invest elsewhere to earn higher yields or returns. Some bought U.S. Treasuries, a low risk version of the trade. Some bought bitcoin or AI stocks, a much higher risk version of the trade. Some invested in Europe or even emerging markets. Overall, the unmeasurable size of the trade was clearly huge. So, the ripples were global as they reduced their positions. The appreciation of the yen—and every position went through the yen– inflicted huge losses on this trade over the last two weeks, in contrast to the huge profits they made over decades. The rebound in global markets yesterday and today suggests that the rush to the exits is now over. It is very unlikely the unwind is complete. But any additional unwind will be highly manageable as long as all these investors are not trying to do it at the same time. And the rebound in markets yesterday and today gives those still in the trade an opportunity to get out at less painful prices, which reduces the risk of another large downdraft.
Domestically, the decline in U.S. equities was also blamed on the heightened risk of a recession as implied by the “weak” jobs report. The data shows that growth is slowing, but it hardly signaled recession, which some were saying. Rather, our markets were likely far more affected by the unwind of the yen carry trade. But some pundits got carried away, as they invariably do in their effort to maximize clicks and visibility.
Where do we go now? As I’ve said frequently, forecasting is difficult, especially when you try to forecast the future. Nonetheless, I think calm will lead to more market gains. The Fed will likely cut rates by 25 basis points in September, and that will be seen as the start of a new trend. Moderate economic growth and hopes for some additional moderation in inflation is a great combination for the stock market. It should go without saying that there may be some additional volatility, since when was the market not volatile? But the future ripples will be far less intense. So, I’m positive on the outlook. I think it is safe for us to return to enjoying the rest of the summer.
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