Carrymageddon

What just happened to markets on our holiday Monday? Most are still scratching their heads as to what happened as the market weakness from last week took an abrupt turn for the worse. The S&P 500 dropped 3% Monday but was down 4.2% in early trading, putting the index at a 10% decline from its high in mid-July. The NASDAQ dropped 3.4%, putting it off 13% from its July high. But this wasn't the big story.

The volatility index (VIX) climbed from around 20 to 65 at the market open before calming down to settle in the high 30s. Looks to be opening around 31 to start Tuesday's trading. To provide some context, the VIX peaked at 85 during the COVID bear. 65 was pretty close to 85, but this isn't that. This appears to be a closer resemblance to the 'Volatigeddon' of early 2018. As a quick refresher, volatility started to rise for more normal economic reasons but it then triggered the implosion of several short-volatility ETFs in January of 2018. These short volatility strategies had produced great returns thanks to historically low volatility over the previous couple of years and gained increasing assets. It was also a crowded trade among hedge funds/quants.

In 2018, the spike in volatility was too much, and many strategies started to unwind. In so doing, they were net sellers of market exposure, which accelerated the market decline and increased volatility even more. And then they were gone, or at least nearly gone. While these products do exist today, thankfully, product folks have made them somewhat safer, and their size isn't what it used to be.

Instead, this market volatility looks more like a very rapid unwind of a very popular carry trade. A carry trade involves borrowing at a low interest rate and re-investing the proceeds in a higher-yielding investment. When interest rates moved higher in most jurisdictions starting in 2022, including the U.S., and interest rates stayed low in Japan – the carry trade was on! Investors would borrow money in Japan, paying really low rates, and invest in the U.S., which could have been through treasuries or even the U.S. stock market.

This trade is effectively shorting the yen. The yen had remained relatively stable at 110 to the USD for years until the Fed started raising rates while the Bank of Japan kept theirs around zero. The yen then continued to weaken from 110 in March of 2022 to 160 this past July (that is how much yen it costs to buy a dollar). That is a serious devaluation of a major developed currency over a couple of years. And for the folks with a carry trade on, it increased the profitability since they were borrowing in yen. Yen becoming cheaper made their liability less. Making money on the yield differential and on the currency. Juicy!

Now, it looks like there was a stampede for the exit. The yen climbed from 162 to 144 over the past couple of weeks, with the biggest daily moves being made in the last few sessions. No clue what triggered this apparent unwind. Maybe it was the softer U.S. economic data that elevated Fed Rate cut expectations. That would start to diminish the profitability of the carry trade. As some started to exit in previous weeks, that increased to a near stampede on Monday.

Here is why we think this is a rapid unwind of the carry trade:

1. The yen has been appreciated a ton, very quickly, for no real economic reason.
2. The U.S. dollar was down on Monday. One would think during such a risk-off day, the U.S. dollar, as often viewed as a safe haven currency, would have risen. It didn't because folks were selling USD to cover their yen short positions.
3. Last week, with softer economic data, U.S. yields kept falling. On a huge risk-off day like Monday, one would think yields would fall… they didn't. In fact, the shorter yields rose. Unwinding the long side of their carry trade had them selling Treasuries.

This may be a simplification that likely has many other moving parts. It could also be the options market that has become massive. Of course, the important question isn't really why it happened but what happens next.

What Happens Next

Of course, this could continue, and it could morph into something different. Big market moves like this often expose those not wearing pants (or those with too much leverage). And it is difficult to ascertain how big the carry trade had become. Some estimate it is half unwound, but it's really hard to say.

The good news is this appears kind of mechanical, a rapid unwind of the carry trade exacerbating the move in pockets of the market, bleeding into the overall market. A mechanical unwind of big trades creates the mispricing of assets. So unless this carrymageddon spreads to cause further damage or bleeds into the real economy, this could prove to be a buying opportunity.

Everyone has become more aware the economic growth of early 2024 has slowed. But it does appear early to get worried about recession. Our market cycle indicators have slipped a little but still remain decent. And if the economy remains in growth mode, albeit slower, then a correction is an opportunity.

If an opportunity, well timing is everything. On this, the data is rather mixed. Two reliable indicators flashed buy signals on Monday – the spike in the VIX was one, and the S&P 500 relative strength (RSI) breached 30. Over the past 30 years, this combo has been a very reliable signal, with the biggest exception being in 2008. So unless you think the financial system is on the verge of collapse, this Monday signal looks encouraging. We did some buying across our Purpose Active multi-asset portfolios on Monday. When markets move, long weekends get cancelled.

But we did say things are mixed. Ideally, this corrective phase would be longer in the tooth. Its speed certainly leaves the door open for more weakness. It would also be nice if market breadth was weaker. Currently, about 45% of S&P 500 members are trading above their 50-day moving average. This metric is a more reliable buy signal when lower.

Final Thoughts

Diversification and well-constructed portfolios remain the prudent path. And if courageous enough to do some bottom fishing, certainly maintain a defensive tilt and keep some powder dry. There may be more to come. Clearly, market volatility in the second half of 2024 is going to prove much more challenging than the first half.

— Craig Basinger is the Chief Market Strategist at Purpose Investments

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Sources: Charts are sourced to Bloomberg L. P.

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