Ask the average investor what inflation or unemployment is, and they can probably give you a good working definition. Ask them about the ‘carry trade,’ and you’ll likely get a blank stare. Even the term itself isn’t intuitive.
But a sudden unwinding of the carry trade forced a market wipeout in Japan on Monday, and weakness spread across the globe.
According to Reuters, the best-known measure of Japanese stocks shed 12% on Monday, the worst trading day since October 1987.
The damage was more contained at home, with the Dow shedding just over 1,000 points, or 2.6%, according to the Wall Street Journal. As the week progressed, cooler heads prevailed, but let’s return to our original thought—the carry trade and its influence on trading last week.
What is the carry trade?
Simply put, borrow in a low-rate or no-rate currency, like the Japanese yen, and take the proceeds and invest in what are expected to be higher-earning assets, such as Japanese stocks, U.S.-based tech stocks, or even higher-earnings Treasury bonds.
Sophisticated investors who place such bets are aware that the carry trade can suddenly blow up (via rising borrowing costs, a rising yen, or a selloff in the assets being purchased). They also gambled that the low-volatility environment in Japan would persist. It didn’t.
You see, while the rest of the world was raising interest rates in 2022 and 2023, Japan kept its key rate near zero. That made the carry trade profitable.
However, that began to change at the end of July when the Bank of Japan increased its key rate to 0.25% and announced that it would gradually reduce bond purchases (Bloomberg).
Consequently, the yen soared, and margin calls forced the pension funds, institutions, and hedge funds that had taken advantage of the carry trade to liquidate positions. Call it an unwinding of the carry trade.
Markets calmed down when the governor of the Bank of Japan began to rethink talk about rate hikes when markets were unstable. On Thursday, JPMorgan estimated that about three-quarters of the carry trade had unwound, according to Bloomberg.
Meanwhile, the labor market is softening, and odds of a recession have risen, but talk of an imminent downturn seems premature, which also helped markets stabilize.
As of August 8, the Atlanta Federal Reserve said its Q3 GDPNow model is tracking at a 2.9% annualized pace. Yes, it’s very early in the quarter, but 2.9% is far from recessionary.
Stats and the Playbook
Since peaking on July 16, the S&P 500 has shed 8.5% through Monday, August 5, its most recent low (S&P data from Yahoo Finance).
According to LPL Research, the S&P 500 averages a 10% correction, or more, every 12 months. The last such 10% pullback occurred almost a year ago.
What has happened since mid-July is far from unusual. What would be unusual? A calendar year in which the S&P 500’s maximum peak-to-trough decline failed to exceed 8%.
Intuitively, investors recognized that. But when a pullback unexpectedly occurs, it can create jitters.
We have entered the historically uncertain months of August and September. On top of that, the upcoming election and tensions in the Middle East loom.
We know that volatility can sometimes be unnerving. Yet, we also know that market pullbacks are to be expected from time to time. Pinpointing them in advance, however, is quite difficult. Those who may correctly call one market downturn often struggle to predict the next one.
Successful investors understand that emotion-based decisions are seldom profitable over a long period.
Historically, the key to building long-term wealth has been to maintain a well-diversified portfolio that taps into the long-term upward trend in major stock market indexes while also reducing risks during uncertain times.
It is an investment plan that is carefully tailored to one’s long-term goals, investment timeline, and tolerance for risk.