Is Japan's monetary policy more important than the Federal Reserve's? "Wall Street's oldest trade" still poses significant risks to the global market

Behind the panic in the US stock market in early August, there is a major factor that has not disappeared and is not closely related to the slowdown of the US economy. The reason for the market turmoil at that time was the unwinding of the carry trade.

According to the Wisdom Financial APP, part of the reason for the 12.4% drop in the Nikkei Index in Japan a month ago was that investors were eager to exit the carry trade, triggering a global stock market sell-off. On August 5th, the Dow Jones Industrial Average and the S&P 500 Index recorded their worst performance since September 13, 2022, with the former falling 1033.99 points, a decrease of 2.6%.

Investors are concerned that the significant rise in the US stock market in recent years has been largely due to the convenience of carry trades for borrowing. Carry trade is a strategy of borrowing at low interest rates to purchase high-yield currencies or assets. Due to the Bank of Japan maintaining ultra-low interest rates for many years, investors have bought a large amount of stocks and assets in other countries by trading with the Japanese yen.

Recent data indicates that new carry trades have become active again. According to Ben Emons, Chief Investment Officer and Founder of Fed Watch Advisors, leveraged hedge funds have increased short positions in yen futures.

At the same time, the appreciation of the yen indicates that carry trades may be unwound again. The yen is typically used as a low-yield currency to invest in higher-yield alternatives, and on Wednesday, the yen rose by over 1% against the dollar, with a trading price of about 143.42 yen to 1 dollar on Thursday, one of the strongest levels this year.

In addition, it is expected that after raising borrowing costs from near-zero levels in July, the Bank of Japan may further raise interest rates, which could have an impact on global markets. Currency fluctuations are often largely driven by so-called interest rate differentials, that is, the differences in interest rate policies between different countries. With Japan's rate hike underway, the Federal Reserve is expected to cut interest rates for the first time on September 18, and this trend may continue as US bond yields and the dollar have fallen since June and July.

Steve Barrow, Head of G-10 Strategy at Standard Bank, said, "The unwinding of carry trades does pose a serious threat to the optimistic outlook for risk assets." In a report on Thursday, Barrow wrote that Japan's funds invested overseas through trade and current account surpluses over the past few decades may "reverse" as Japanese interest rates and the yen rise.

Barrow also added that the Bank of Japan, perhaps more crucial than the Federal Reserve, the "chaos" brought about by the soaring yen and falling stock market in August may only be a harbinger of larger changes to come.

Tom Nakamura, Currency Strategist and Co-Head of Fixed Income at AGF Investments, pointed out that similar foreign exchange developments rarely have a broad impact on the US stock market, and looking back at the Asian financial crisis in 1997 may find similar cases Despite the impact of the 2022 UK sovereign debt crisis on the pound and the European bond market, the extent is not as severe as the unwinding of the yen carry trade.

He said that the further unwinding of the yen carry trade remains a significant cross-market risk, with investors concerned about the actions of the Bank of Japan in the next one to two years. Whether it is the slowdown of the US economy or policy decisions of other central banks, market volatility remains high, even higher than in early August.

Emons described the carry trade as "Wall Street's oldest trade" with various forms. For example, carry trades are not limited to the yen and can also involve investments in emerging markets using US dollar borrowings, or reflected in trades between the Canadian dollar and the yen.

Despite the impact of the yen's appreciation in August on market sentiment, Nakamura believes that carry trades as a holistic strategy still remain attractive. He pointed out that the market is already aware of this risk, which helps mitigate its impact; the worst-case scenario is usually unexpected.

He sees the 140 level in the yen against the dollar as a key level. If the yen gradually appreciates to between 130 and 135, this situation is manageable. However, if this appreciation occurs within one to two months, it could cause trouble