Guo Lei: How to view this round of overseas "carry trade" and its impact

The so-called "carry trade" is simply borrowing low-interest-rate currencies and investing in high-return assets. Among economies with developed financial markets, Japan has the lowest interest rates. Since 1998, the policy target interest rate has mostly been below 0.3%, and for a long time, it has been in a state of zero or negative interest rates, making the Japanese Yen the most mainstream funding currency for carry trades globally.

Looking at Japan's policy target interest rates, from September 1999 to August 2000 and from March 2001 to July 2006, they were all in the zero interest rate range; from February 2016 to March 2024, they were in the negative interest rate range; and for most other periods, they were below 0.3%. In February 2007, there was a rate hike to 0.5%, but it was short-lived, and rate cuts began in October 2008 after the global financial crisis.

The most unfavorable situation for this trade is a continuous appreciation of the Japanese Yen. In such a scenario, the funding cost of carry trades increases, and if it includes a depreciation of the US Dollar, it often corresponds to a period of declining expected investment returns in external markets. As cost-benefit expectations change together, there is often significant pressure to close carry trades. Closing trades further brings liquidity pressure and transmission between different markets.

For the Japanese Yen as the funding currency for carry trades, the liability side is in Yen, while the asset side generally consists of high-yield assets, such as post-pandemic US Treasuries and stocks, emerging market bonds, and stocks.

Taking the example of carry trades between Yen and Dollar assets, during periods of Yen appreciation and Dollar depreciation, the cost on the liability side increases, and at the same time, there is a narrowing of the yield spread of US Treasuries and a decline in US stocks, leading to a decrease in asset-side returns. This poses a dual pressure on carry trades in terms of numerator and denominator.

After early July 2024, there was a rapid appreciation of the Yen against the Dollar. One reason was the expectation of a slowdown in the US economy triggering a "recession trade". Starting from the second week of July, the slowdown in US retail data and the unexpected increase in initial jobless claims induced this expectation. Another reason was the Bank of Japan's rate hike and gradual reduction in asset purchases. In June, Japan's core CPI continued to rise, and on July 31, the Bank of Japan implemented a rate hike, with indications of possible further hikes. With the combined impact of these two expectations, the Dollar depreciated, the Yen appreciated, and the USD/JPY exchange rate rapidly changed from 161.7 on July 10 to 146.6 on August 2.

The June inflation data released on July 11 showed a weaker-than-expected trend, leading to market expectations shifting forward for the timing of interest rate cuts.

In the first to fourth weeks of July, the year-on-year growth rates of US Redbook retail sales were 6.3%, 4.8%, 4.9%, and 4.5% respectively In the first week of July, the initial jobless claims in the United States were 223,000, a decrease of 14,000 year-on-year; in the second week, it unexpectedly rose to 245,000, an increase of 17,000 year-on-year; in the third week, it was 235,000, an increase of 14,000 year-on-year; and in the fourth week, it was 249,000, an increase of 22,000 year-on-year.

On July 19th, Japan's core CPI for June was 0.3% month-on-month, staying at this level for the fourth consecutive month; and 2.6% year-on-year, higher than April's 2.2% and May's 2.5%.

The U.S. July non-farm data further reinforced the above logic. The U.S. added 114,000 non-farm jobs in July 2024, significantly lower than the previous value of 179,000; the unemployment rate (U3) rose from 4.1% to 4.3%. More importantly, the increase in the unemployment rate broke the previous upward trend, triggering the "Sam Rule" experientially, and further intensifying concerns about a U.S. economic recession. The 10-year U.S. Treasury yield fell rapidly from 4.28% on July 24th to 3.80% on August 2nd; equity market indices such as the Nasdaq also fell significantly, while the VIX index rose rapidly. An increase in the VIX implies that trades that sold volatility in the previous period also need to be closed out; it may also lead to investment portfolios needing to adjust risk exposure based on volatility (low volatility allows for higher risk exposure, and vice versa), further driving overseas stock markets lower. This further triggered unprofitable carry trades and accelerated liquidation, expanding the cross-market transmission of liquidity risk.

In the previous report "U.S. July Non-Farm Data and the Sam Rule," we analyzed the U.S. July employment data and its impact: the U.S. added 114,000 non-farm jobs in July 2024, lower than the market's expected 175,000, and lower than the previous value of 179,000. In terms of employment breadth, July's 49.6% was significantly lower than June's 56% and the 2023 monthly average of 59.4%, and the lowest level since May 2016. The concurrently released household survey data was also weak. The July unemployment rate (U3) rose from 4.1% to 4.3%. After the release of this data, overseas market volatility significantly increased, the 10-year U.S. Treasury yield fell sharply, and major overseas stock indices also experienced significant declines. The source of overseas market panic partly stems from the increase in the July unemployment rate triggering the "Sam Rule." According to the definition of the Sam Rule, when the average unemployment rate over the past 3 months rises by 0.5 percentage points from the low point of the past 12 months, it indicates that a recession may have already begun.

It is worth noting that the downward trend in the U.S. July non-farm employment data, one of the sources, contains unexpected shocks. In the previous report "U.S. July Non-Farm Data and the Sam Rule," we pointed out that Hurricane Beryl had a certain impact on employment data in July, with a significant increase in temporary unemployment, and there is a high probability of some repair in employment data after the disturbance of the hurricane season. In the report "US July Non-Farm Data and Sam's Law", we pointed out: Hurricane Beryl in July had a certain impact on employment data, with a significant abnormal increase of 249,000 in the number of temporary job losers, accounting for 70% of the total new unemployment.

Looking at the situation of the US economy so far this year, the year-on-year real GDP growth rates for the first and second quarters were 2.9% and 3.1% respectively, higher than the 2.5% for the previous fiscal year. With the background of a higher base in the second half of the year, the year-on-year growth rate is likely to slow down, but there is still a considerable distance from entering the "recession" range. Several characteristics also suggest that the economy is not likely to quickly enter a recession: first, although wage growth is slowing down, it is still at a historically high level, which is a crucial intermediate variable for a consumption-driven economy like the US. Additionally, the high ratio of corporate profits to GDP provides some support for the job market and wage levels; second, historically, external shocks triggering systematic destocking are often one of the transmission mechanisms of a recession, but the current inventory cycle is at a relatively low position; third, there have been significant changes in the US labor force structure after the pandemic, including a large influx of immigrants leading to a substantial increase in the labor force population, which should also result in changes in the applicability and thresholds of Sam's Law; fourth, the rate cut in September is already the baseline scenario, and due to the relatively high policy interest rates in this round, the Federal Reserve has enough policy space, and the improvement in financial conditions after the rate cut will provide support for private sector investment.

First, the position of wage growth. In July, the year-on-year hourly wage growth rate in the US non-farm private sector was 3.6%, showing a noticeable slowdown from the 4.4% at the beginning of the year, but still higher than before 2020. For the chain of "employment-wage-consumption-growth and inflation", wages are a key intermediate variable.

Second, the position of inventories. The position of the manufacturing inventory cycle is also one of the empirical coordinates for judging economic trends. The year-on-year bottom of the current inventory cycle was -0.7% in January 2024, slowly rising thereafter, with only a 0.7% year-on-year increase in June. A low inventory cycle position indicates that there won't be too much elasticity for internal economic downturns.

Third, the change in the comparability of Sam's Law experience. In the report "US July Non-Farm Data and Sam's Law", we previously pointed out: the significant increase in the US labor force population due to a large influx of immigrants after the pandemic, as well as the increased societal tolerance for remote work leading to a significant rise in job seekers and employment among disabled individuals, will both result in changes in the comparability of Sam's Law experience After the subsequent interest rate cuts, financial conditions improved, and capital expenditures also received some support.

In summary, there are some clear driving clues for the unwinding of overseas "carry trade" in this round, and its emergence is also the result of established macroeconomic logic; attention should be paid to the cross-market transmission of overseas liquidity risks it brings. However, there is currently no evidence to confirm its two key assumptions (U.S. recession, Japan's continuous rate hikes), and if the financial markets fluctuate too much, it may imply short-term overcorrection. For domestic assets, a key point to observe is whether overseas microeconomic and nominal growth have been explicitly affected, which will be transmitted to the domestic economy through exports; and the impact of mere overseas financial market fluctuations should be manageable during the stage of RMB appreciation as a non-U.S. currency.

On August 5th, the China Securities Journal reported that the Nikkei 225 index closed down 12.4%, a 26% drop from its July high, with two circuit breakers triggered during the trading session, wiping out all gains so far this year. The South Korean KOSPI index closed down 234.62 points, a decrease of 8.77%, briefly triggering the circuit breaker mechanism.

Author: Guo Lei from GF Macro (Practice License Number: S1220515070001), Source: Guo Lei Macro Tea House, Original Title: "How to View the Unwinding of Overseas 'Carry Trade' in this Round and Its Impact"