Behind the global stock market crash: Arbitrage trading is the main culprit, is the US hard landing just a scapegoat?

According to the Zhitong Finance APP, analysts say that the recent global stock market crash is more of a reflection of a decrease in arbitrage trading by investors looking to increase their bets, rather than a sharp change in the US economic outlook.

They added that while last Friday's weaker-than-expected US employment data was the catalyst for market selling, the Nikkei Index, a Japanese blue-chip stock, suffered its largest single-day drop since Black Monday in 1987 on Monday. However, the employment report itself is not sufficient to be the main factor triggering such intense volatility.

Instead, the answer may lie in a significant further unwinding of arbitrage trading. Arbitrage investors borrow funds from economies with lower interest rates such as Japan or Switzerland and invest in higher-yielding assets elsewhere.

With the yen rebounding more than 11% against the US dollar from the 38-year low touched a month ago, these investors are in a predicament.

Arbitrage Trading Collapse

Mark Dowding, Chief Investment Officer of BlueBay Asset Management, said, "In our assessment, this (market sell-off) is largely attributed to position surrender, as many macro funds made mistakes in trading and triggered stop-loss, starting with foreign exchange and the yen." He referred to pre-set levels that trigger buying or selling.

He added, "We have not seen any data indicating that the economy is facing a hard landing."

An Asian investor who declined to be named said that after the unexpected rate hike by the Bank of Japan last week sparked further expectations of tightening monetary policy, some large systematic hedge funds that trade stocks based on algorithm signals began selling stocks.

Although it is difficult to obtain exact position change data, analysts suspect that the crowding of US tech stock positions funded by arbitrage trading is the main reason why these stocks have been hit hardest.

As of Monday's close, the US Nasdaq Index, dominated by tech stocks, has fallen 8% so far in August, while the S&P 500 Index has fallen by 6%.

ING Group stated that driven by Japan's years of ultra-loose monetary policy, arbitrage trading has sparked a cross-border yen borrowing frenzy, providing funds for transactions in other regions.

Data from the Bank for International Settlements shows that since the end of 2021, cross-border yen borrowing has increased by $742 billion.

Tim Graf, Head of Macro Strategy for Europe at Daiwa Capital Markets, said, "This is the unwinding of yen-funded carry trades and the unwinding of the Japanese stock market." "Our position indicators show that investors have increased their holdings of Japanese stocks. They had previously reduced their holdings of yen. Now they are no longer reducing their yen holdings."

The latest weekly data from US market regulators shows that speculators have significantly reduced their bearish bets on the yen in recent weeks, reducing net short yen positions to $6.01 billion, the lowest level since January, below the seven-year high of $14.526 billion reached in April.

Kit Juckes, Chief FX Strategist at Societe Generale, said, "You can't unwind the largest carry trade in history without hurting some people."

Trends in the Japanese stock market and the yen

Hedge Funds in Trouble

Some investors say that hedge funds, which typically raise funds through borrowing, are exacerbating market volatility with their adjustments.

Banks provide leverage to hedge funds, amplifying their returns but also potentially increasing losses.

A report from Goldman Sachs last Friday showed that in June and July, the total leverage ratio of Goldman's prime brokerage business (i.e. the total amount borrowed by hedge funds) has decreased, but still remains near a five-year high.

In another report, Goldman Sachs stated that last week, bets by hedge funds on a bearish stock market exceeded bullish bets for the third consecutive week, with every additional long position corresponding to 3.3 short positions.

Goldman Sachs also mentioned on Monday that as of the Asian market close, hedge funds focused on Japan had fallen by 7.6% over the past three trading days.

Investors noted that while macro funds may have been involved in forex trades related to the Japanese yen, many stock trading hedge funds have shifted their focus to Japan due to regulatory pressures from South Korea's ban on short selling in June.

Analysts added that with positions being unwound, there is still room for further declines in the short term, but market volatility will be limited.

Traders currently expect the U.S. to cut interest rates by over 120 basis points by the end of the year, up from about 50 basis points at the beginning of last week, fully digesting the expectation of a 50 basis point rate cut in September.

If the upcoming data shows that the U.S. economy is likely to avoid a hard landing, these expectations may be somewhat overdone.

Dowding from BlueBay said, "We believe that fundamentally reassessing the outlook at this point is a mistake. Doing so is just creating a narrative to cater to price movements."