Amid the recent market volatility, I'm suddenly hearing a lot about something I honestly haven't spent much time on.
The Yen Cari trade, which now seems to be one of the biggest focal points for investors.
So what is the Yen Cari trade?
Why did it break down? And what does it all mean for global markets?
I'm Allison Nathan and this is Goldman Sachs exchanges.
Today I'm speaking to Kamakshi Atravetti, the head of Global Foreign Exchange, illustrates an emerging market strategy research and to pre-need Shah, who is co-head of Global G10 FX Options Trading in our Global Banking and Markets Division.
Kamakshi Atpre-Need, thanks so much for being here today.
Thanks for having us Allison.
Yes, thank you Allison.
Kamakshi, let's start on a very basic level.
What are carry trades? How do they work or at least how are these supposed to work?
Yeah, so at a very simple level, a carry trade is a strategy or an investment strategy where an investor borrows in a currency where interest rates are low and in West in a currency where interest rates or what is often called in the jargon carry, the carry or interest rates are higher.
And so essentially that strategy allows them to earn the spread between the low interest rate currency where they were borrowed and the high interest rate currency where they are investing.
And typically the kicker in these types of trades comes from the fact that in addition to the interest rate spread, if the currencies actually move, so the currency with the low interest rate depreciates against the currency with the high interest rates, the investor earns not just the carry or the interest rate spread, but also they benefit from the relative
currency move. So in the context of what we are discussing today, a common example of the carry trade was the yen was a very low yielding currency with interest rates that had been pinned at zero for many years, whereas in comparison to that, the US dollar or US interest rates which went up quite meaningfully after the pandemic surge in inflation, as you had nearly
a 5 percentage point gap between interest rates in Japan or what you could borrow in the end versus what you could earn by investing in assets in bonds in the US.
And if you took a even more higher yielding version of that trade, if you invested in emerging markets, another common version of this which was borrowing in Japan or yen and that investing in Mexico, that spread was nearly 9 to 10%.
So that's the kind of carry trade that we are talking about.
Okay, got it. So from your seat, you see actual flows into these trades.
So how long have they been a feature of the market and who's really trading these positions and how has it evolved recently?
These trades have already been a feature of the market for a long time now.
You last saw a proliferation in these trades back around the Lehman crisis around 09 where you also saw the subsequent unwind in the years after.
I think the second wave of yen carried trades really have been in existence since 2016.
This is when the Japanese employed negative interest rates.
So it became an even more attractive funder relative to the rest of the world.
So they've been around for a long time, but you've only really seen a heightened use of this strategy in 2023 because it's one of the best sharp ratio trades that you could employ across multiple strategies, effects carry.
And you went into the start of this year, where the macro narrative was this immaculate disinflation.
So this is inflation cooling off within a very benign growth backdrop.
So a lot of our hedge fund franchise, CTS in particular were funding in yen.
You also saw real money looked to fund longs in the likes of Mexico that you'll be 10% borrowing in Japan at zero.
So the start of this year, you really did see a real increase in positioning and you got to real extremes in July just at the start of the summer.
When you look at our positioning metrics, they all indicated record yen shorts.
So it gives you a real indication as to how large these positions really had built.
And this took pretty much six months to build over the start of the year and they continue to be added to in what was supposed to be a quite summer.
And it was supposed to be a market in which you'd hope to earn carry and where vol would realize low over the summer months.
And then there is this institutional side, which is more entrenched, correct?
Yeah, so if you have one side of our franchise that is the more speculative flow, which is the hedge fund that CTA has mentioned, these are the pension fund investment trusts that all manage money in Japan that can't find the rate of return at home.
So they end up buying treasuries call it a five percent.
Now the cost of currency hedging these is very prohibitive.
So what's essentially ended up happening is they've just bought these foreign assets currency unhaged.
And as a result, they basically end up in an open FX position and this in essence is a carry trade.
So if you look at our data with a historically these hedgeray shows about 60% of investments have been currency hedged.
Right now they're at multi-year lows around 45%.
And it goes to show the level of conviction even from the institutional money in Japan to continue to buy foreign assets through the course of this year.
And it really started back in 2022 when Japan really got left behind in the global hiking cycle.
So come actually we now understand what the carry trade is.
We understand how popular of a trade it had become.
So what drove the unwind of this trade in what seems to be a very short period of time in recent weeks.
Yeah. So I think that if you go back to what we were discussing, both sides of the equation have started to shift, which is there was reasons for rates to start going up in Japan.
And there have been concerns around US economic activity concerns around US recession risk that of course, US rates to start gradually coming down as inflation has cooled.
So if you go back to what we were talking at the top, which is the attractiveness of these kinds of carry trades is really the interest rate differential or the spread that you can earn.
And then the currency kicker.
What's really happened over the past few weeks is that spread has started to narrow.
It started to narrow on the one hand because the Bank of Japan has finally after many years of being pinned at zero or below started to move rates higher.
And there was somewhat of a surprising interest rate hike that we saw from the Bank of Japan in July that was not completely well anticipated by the markets, but currently forecasted by our economists.
And on the other hand, you got a series of somewhat weak US data points, most particular amongst that an employment report that came after some weak inflation readings.
And so the market started to worry about and price in the possibility of weaker US economic activity and more particularly rapid cuts by the Federal Reserve.
And so we saw from both sides of this that interest rate differential start to shrink and the yen start to appreciate the relative to the dollar.
And then part of these moves were very volatile because as Pranid said, people were very engaged in those trades or these trades were very crowded in opposite directions.
That's the I would say the economic cause for why we saw some of these moves starting to unwind.
I think it's also fair to say that we saw some other coincidental news whether it was on micro earning, etc.
that sort of caused volatility at the same time as well.
And Pranid, when you think about how crowded these trades were and you think about how big the moves were, how did that play into how all of this unraveled?
Yeah, I think obviously like you said before that we sort of record the end shorts just prior to the start of this move.
But if you actually drill down into our positioning data, we actually saw the largest change in monthly positioning.
It's going to see started taking record.
So it gives you an idea of the wholesale liquidations or positions that you've seen, especially on the speculative side of our flows over the past few weeks.
We basically saw record shorts in yen.
And now they're pretty much paired all the back downs are flat.
So Pranid, come actually I just talked about the catalyst behind some of the unwind here.
But when you think about the positioning that you look at every day and the types of funds that are owning these, how did that contribute to just the speed of the unraveling that we saw?
Yeah, I think when you saw a drawdown first start within an initial appreciation in yen, it caused quite a bar shock across multiple portfolios.
So bar meaning value or risk.
It's a pretty much a risk management model that a lot of funds employ to manage max drawdowns.
So when you're seeing a drawdown in one aspect of a portfolio, it has a ripple effect across the rest of your line items.
So purely due to risk management purposes, if you're seeing a drawdown in what was pretty much concentrated trade held across multiple funds, you see this ripple effect I've just spoken about whereby your force of a pair down risk across all your other line items.
Though it almost has itself reinforcing effect when you've got yen as the funder for other prosypical long risk trades and you're seeing this unloudered, you have this negative feedback loop.
So not only did we start to see other assets start to move such as equity positions, even dispersion trades that aren't even really related to the yen carry trade per se.
It had a pretty widespread impact across other markets.
And I say it lars me due to this position powers that you saw and a varshock essentially that ended up resulting in positions needed to be paired down across the board.
So essentially even if you have conviction in a trade that's unrelated, you may actually have to unwind that position because of the var implications of the big moves in the yen carry trade, for example.
Yes, that's socially right.
And this is not just huge global macro funds that had these positions.
They were smaller funds too, right?
So wouldn't they feel the pressure maybe more quickly when we think about these types of moves and how big they've been?
Yeah, when you look at that aspect of the flow that we saw, when you have especially these multi-manager funds where you have lots of smaller allocations of risk all managing the safe and trade, you end up having to pay a risk out a lot quicker than some of the more single manager funds to have a much higher tolerance for a drawdown.
So it's almost a cascading effect whereby you've got lots of smaller pools of capital now all drawing down at the same time.
You end up hitting risk limits a lot quicker than you historically otherwise would have outside of this type of a market structure.
So beneath the million dollar question is how far are we into this unwind?
I think it's important to break down the flows into two separate sets.
So if you start with a more speculative flow and that's flow that tends to be much higher frequency faster moving, that's our hedge fund CTA, that element of it that's caused the marginal move over the last few weeks.
So our positioning data tends to capture this aspect of the flow a lot better.
And you can see these record Yen shorts have pretty much been paired all the way down to flat.
So in terms of positioning from this element of our franchise, it really does look as though the worst may be over.
However, again, like you said, the multi-trillion yen question actually could be what's actually happening with institutional money in Japan.
This is the flow that's really been entrenched over the last few years as 2016, it's proliferated since 2022.
Here you've got two sets of flow.
One is Japanese retail.
This again turns to be slightly faster moving.
It's very likely that they will have hit margin calls on the way down in Dolly-Anne and Cross-Yak.
So I estimate that this is pretty much mostly cleaned up.
However, institutional investors in Japan, I think this is the one that's much more difficult to gauge.
Here we've seen various estimates of how much holdings they've got.
So they've actually got called it two trillion US dollars of foreign bond holdings in total, this community.
We estimate that especially the pension fund industry, they've only really currency hedged 45% at the moment.
If you look at the equity side now, we estimate that they have about another trillion US dollars of equity holdings that could be susceptible to an FX move as well.
So these are pretty sizable numbers, but we don't really have that firm a handle on how much of this part of the portfolio that potentially needs to be unbound.
Again, this flows a lot stickier.
It's a lot slower moving.
Years of entrenched positioning don't just get washed away in a few weeks.
So yeah, I don't think this part of the onwind is still over.
I think there's a lot of flows that could yet to become.
And it mostly will be propagated by further strengthening in Yen.
But again, this negative feedback loop really is still there at the forefront of what the markets think here about.
Are there other reasons why the positioning might remain sticky in these institutions, even if the trade moves against itself?
Yeah, I think you can approach this in two ways.
So one, right now, like I said, hedge ratios look like they're at 45%, they've typically been closer to 60%.
But on the margin, if anything, if you see these moves in Yen, you're likely to do one of two things.
You either increase the hedge ratio or you start to pair down holdings or foreign assets.
In both those instances, it involves every patrion back into Yen.
However, if you put aside this need to rebalance your hedge ratio and you just look at the bigger picture here, I can easily see a scenario in which let's say the US manages to avoid a recession.
Then you're back in this benign disinflation narrative again.
The Yen suddenly starts to stabilize and let's face it, I know the B.A.J.
He height rates, 15 basis points, but the rounding error is still close to zero.
The US still has 5% rates.
The Mexican peso still has 10% rates.
You still have an attractive yield differential here.
And if the US were to avoid a recession, there wouldn't be any real underlie reason to start a massive reallocation away from foreign assets.
So yeah, I think that's pretty much the thing you'd be looking at.
The US recession period, I think, did the driver come actually if we think about the broader context as the narrative that the extreme volatility in equity markets ties back to the unwind of these carry trades.
True or is that overblown?
So the Yen carry trade, even in the past week, I think has been blamed for a lot of this market volatility that we've seen.
That's been the cause of some of the big drawdowns we've seen across equity markets despite getting volatility.
I think some of that is reasonable.
I think carry strategies in some way, shape or form have been pretty ubiquitous across global asset managers at macro funds.
So whether that is funded out the Yen, funded out of the Chinese Renminbi, I think people have had some of these types of FX carry strategies in portfolios as delts have come under pressure.
That's naturally going to have a knock on effect on other parts of their portfolios.
I think that part of it is reasonable.
What I think is a little bit of an overstretched or an overclaim is that all of the volatility, especially the volatility that we saw in Monday has to do with the Yen carry trade.
Japanese stocks will probably the biggest move words on that day that dropped by more than 10%.
Yen carry trade was not one where people were boring and Yen and buying Japanese stock.
They were buying overseas assets.
Some of this is just that you also have had at the same time some disappointing earnings, some questioning of the broader artificial intelligence team, and just generally some fraughty overpositioned equity markets going into the summer where you had some bad data and concern around US recession picking up.
So my view is that yes, there's been some spillovers elsewhere whether it is in the weakening in Latin American currencies where you know which were on the other side of some of those carry trades, whether it's the kind of strengthening in C and Y which was used as a funder in sympathy with the Yen.
But I think some of the broader market volatility is specifically in equity markets.
I think is also just a function of the coincidental timing of how some of the news flow has evolved on the macro and the micro side.
So just some bad luck here with all this coming together at one time.
Yes, a little bit of bad luck.
It's often the case that when you have markets at a high level, when you have particular trades that are very highly crowded and concentrated and it doesn't take very much to move things the other way, there were some genuine fundamental reasons for some degree of unwind in the Yen carry trades specifically that we talked about some genuine fundamental shifts
in the macroeconomic picture in Japan and the US.
But I think some of the broader volatility does feel to me like some few different things came together in a sort of perfect storm.
And what should we take away from that if we think about the broader market structure in terms of has it gotten to brittle has it gotten to interdependent in a way that we can see these very vicious bouts of volatility.
I think what's interesting about this risk episode in particular is the way it's all unraveled.
So if you take the last risk shock which is 2020, COVID was a pretty exogenous event.
You saw this big shot people re-rated down their growth expectations.
The Yen started to appreciate but this was all correlated together.
Stocks shredded lower.
Yen took a safe haven bid.
But I think in this episode it's very interesting to know the degree of indogeneity you're seeing here.
You saw this initial appreciation in the Yen after the authorities intervened.
And I think it's this negative feedback loop that I think has caused the brittleness in this case.
So you've seen a whole host of investments funded out of Yen.
The price of these investments does start to trade lower which in turn causes a further need to unwind.
So here you've actually got this negative circularity which actually may not have been apparent in the previous ratio such as COVID.
So I think this one's a bit more unique in the people had actually funded in a specific currency like the Yen.
But positioning really did get to euphoric levels at the start of July which obviously hasn't helped.
Can actually make a good point in the a lot of it may well be correlation and not causation and there's a lot of factors that all lined up at the same time.
But I think it's this indogeneity aspect of this risk shot that has had much bigger ripple effect relative to what you've had in previous instances such as COVID that have been a bit more exogenous.
But is that indogeneity just a feature of the market at this point?
I think it's a feature of the market that funds itself in a common currency and holds pretty much concentrated risk across a similar set of trades.
And I think it's this feature of the market that really induces brittleness in the market where you do have a sharing of positions all concentrated especially in a setup such as the multi manager one which you just discussed where you've got a big pool of capital that used to be managed in a more concentrated way.
Thuddenly managed across lots of smaller pools of capital each with tighter risk limits.
You end up with this cascading effect again whereby a bar shock in one element of the portfolio ends up actually having a much more amplified effect elsewhere purely because these positions are all correlated to a much bigger degree than we will expect to them to be.
Can I actually get any lessons you take away from this recent episode?
Yeah, I think I would echo some of the things that Pranid said.
I think it's the fact that you had quite a crowded position, one that has built up over many years and perhaps some degree of complacency that the macro outlook that underlined that position that the US would continue to be exceptional and strong and that Japan would struggle to raise rates and generate inflation.
There was a lot of complacency around both those assumptions.
Both of those have come into question in recent weeks and that's caused very big reverse.
On the back of some of those changed market microstructure dynamics that Pranid just described.
But what I'm hearing from you is this may not be the end of the carry trade.
It really just depends on how the macro conditions evolve from here and in particular between the US and some of these other countries with low yielding currencies.
Absolutely not. I think that the carry trade as I go back is very simply just borrowing in a low yielding currency and investing in a high yielding currency.
That is going to stay with us.
It's been with us well before.
Yen became the kind of dominant low yielding currency.
It's going to stay with us well after.
Already I would say even in the past week, seeing some people re-engage in it, move their funding currency or borrowed currency to the Chinese Red Minbivir.
Perhaps the fundamental case for rates to remain low at this point is stronger than it is in Japan.
So there will always be a low yielding currency to borrow from in a high yielding currency to invest in.
That carry trade is going to be very much with us.
This particular one has got long in the tooth, got perhaps a bit too crowded and saw some adjustable reason to have some unwind.
But it's definitely not the end of carry trades.
As we've discussed in Kamakashiyo just said, carry trade not over.
But when could we see the interest in it rise again?
I mentioned at the start that 2023 FX Carry was one of the best performing sharp ratio strategies out there.
I think an important part of the equation is the realized vol of the return.
So Kamakashiyo mentioned that you still will have this potential return investing the USF 5% borrowing Japan at 0%.
But a key input is how volatile is that return like me to be?
So right now, you've seen a Schum spike in implied volatility in Dolly-N because of how nervous the market is, how volatile it's been.
And it's very difficult to re-engage in carry strategies when realize an implied vol those so elevated.
So again, given that Yen has been the epicenter of all the moves you've seen recently, it's very difficult to see people really re-engaging in prosick legal long risk trades just yet, whilst Dolly-N vol remains elevated.
So you can look at the term structure to see what's priced.
I see Dolly-N returning to a bit more of a normal market regime, not only until around mid-November time.
This is post-TheUS election.
So that's still some weeks or even months away before you really see a normalization.
So we could be waiting a long time, I think, if this elevated period of uncertainty continues to remain before people really look to re-engage.
And longer if the US economy disappoints and we end up in recession and the macrocondition shift.
Oh, it's very conditional on the US growth outlook.
We've got payrolls coming up in September, just before an all-important EFOMC meeting.
There's a whole host of macro variables that you really need to be keeping an eye on.
So yeah, there's two parts here.
There's one the outlook for the US and global economy, but two, how much of a risk premier we continue to place in Yen, realize, an implied vol.
Come up, Shia Puneet. Thanks again for joining us.
Thank you, Alison. Thanks, Alison.
This episode of Goldman Sachs exchanges was recorded on Monday, August 12, 2024.
I'm your host, Alison Nathan.
And if you want to hear more from Goldman Sachs, listen to The Markets.
Every Friday, we break down what's going on in the markets, and what could come next.
Check it out on your podcast platform of choice.
Thank you for listening.
The opinions and views expressed in this program may not necessarily reflect the institutional views of Goldman Sachs or its affiliates.
This program should not be copied, distributed, published, or reproduced in whole or in part, or disclosed by any recipient to any other person without the expressed written consent of Goldman Sachs.
Each name of a third-party organization mentioned in this program is the property of the company to which it relates, is used here strictly for informational and identification purposes only, and is not used to imply any ownership or license rights between any such company and Goldman Sachs.
The content of this program does not constitute a recommendation from any Goldman Sachs entity to the recipient, and is provided for informational purposes only.
Goldman Sachs is not providing any financial, economic, legal, investment, accounting, or tax advice through this program or to its recipient.
Certain information contained in this program constitutes forward-looking statements, and there's no guarantee that these results will be achieved.
Goldman Sachs has no obligation to provide updates or changes to the information in this program.
Pass performance does not guarantee future results, which may vary.
Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, express or implied as to the accuracy or completeness of the statements or any information contained in this program, and any liability therefore, including in respect of direct, indirect, or consequential loss or damage is expressly disclaimed.
