I’m currently sitting in the Miami Airport watching the market and thought I’d give you a quick update on what’s happened to initiate this correction.

Understanding the Impact of Yen Carry Trade Unwind on US Stocks

The financial markets are a complex web of interconnected trades across multiple markets all at the same time. One of those interconnected trades is happening right now.

The sharp rise in the JPY/USD exchange rate this weekend has caused a massive unwind of Yen carry trade positions and contributing to a significant decline in US stocks.

For those who are not familiar with how this works, let’s look at the details and understand the causational factors behind these market movements.

What is the Yen Carry Trade?

The Yen carry trade is a popular financial strategy that has been used for decades by hedge funds and institutional traders. It is a leveraged trade where traders borrow Japanese Yen (JPY) at low interest rates and convert them into US Dollars (USD) to invest in higher-yielding assets, such as US stocks.

This strategy is attractive because Japan has historically maintained very low interest rates, making it cheap to borrow JPY. By converting the borrowed Yen into USD, traders can invest in assets that offer higher returns, thus potentially profiting from the interest rate differential.

The Role of Interest Rates and Exchange Rates

To understand the current market dynamics, it’s crucial to grasp the role of interest rates and exchange rates in the Yen carry trade. When the Bank of Japan (BOJ) maintains low interest rates, it encourages borrowing in JPY. However, recent changes in BOJ’s monetary policy have led to an increase in interest rates, significantly strengthening the JPY against the USD.

Interest Rates and Borrowing Costs

As the BOJ raises interest rates, the cost of borrowing JPY increases. This means that traders who previously borrowed Yen at low rates now face higher interest payments. The increased borrowing costs can erode the profitability of their investments in US assets, prompting a reassessment of their positions. However, this is the small part of the impact on the selloff. The bigger part has to do with the exchange rate between the Yen and the Dollar.

Exchange Rate Fluctuations

The strengthening of the JPY against the USD has major implications for traders engaged in the Yen carry trade. When the JPY appreciates, the value of the Yen-denominated debt increases relative to the USD-denominated assets. This can lead to substantial foreign exchange (forex) losses for traders, as the USD assets they hold may not be sufficient to repay the JPY they borrowed. As the value of the collateral for the loans falls, the Japanese banks begin to call the loans and the borrowers have to sell the collateral – in this case, stocks and bitcoin – that were bought with the borrowed funds.

The Unwind of Yen Carry Trade Positions

The combination of higher borrowing costs and significant forex losses is forcing many traders to unwind their Yen carry trade positions. This unwind process involves selling US stocks and crypto currencies to raise USD, converting the USD back into JPY, and repaying the borrowed Yen. Let’s break down the causational factors in detail:

Margin Calls and Forced Liquidations

When traders face significant losses, they often encounter margin calls from their brokers. A margin call requires traders to either deposit additional funds or liquidate their positions to meet the required margin levels. In the context of the Yen carry trade, this means selling US stocks to raise USD. The forced liquidation of US stocks adds selling pressure to the market, leading to further declines in stock prices.

Selling Pressure on US Stocks

The mass unwinding of Yen carry trade positions creates a domino effect. As more traders sell their US stocks to raise USD, the increased selling pressure drives down stock prices. This decline can be exacerbated by the actions of other investors who may panic and sell their holdings, further fueling the downward spiral.

Broader Market Implications

The unwinding of Yen carry trade positions doesn’t occur in isolation. It interacts with other market factors, amplifying its impact on US stocks.

Geopolitical Tensions and Uncertainty

In addition to the financial mechanics of the Yen carry trade, geopolitical tensions and political uncertainty can exacerbate market volatility. For instance, escalating conflicts in the Middle East or political unknowns in the US can create an environment of fear and panic among investors. This heightened uncertainty can lead to more aggressive selling of US stocks, compounding the effects of the Yen carry trade unwind.

Economic Uncertainty

investors are now also worried about the prospect for a recession. When the Fed did not cut rates last week many investors were disappointed. That is immediately followed by a bad jobs report that indicated a significant weakening in the economy.

Investor Sentiment and Market Psychology

Investor sentiment plays a crucial role in market dynamics. During periods of panic and uncertainty, negative sentiment can spread quickly, leading to irrational decision-making and herd behavior. As traders and investors react to market declines, they may sell their holdings indiscriminately, further driving down stock prices. Understanding market psychology is essential for navigating these turbulent times.

Opportunities for Savvy Investors

While the Yen carry trade unwind and its associated market turmoil may seem daunting, it also presents opportunities for savvy investors. Short-term crises and panic can create temporary mispricing in the market, allowing astute investors to scoop up high-quality US stocks at significant discounts. Here are some strategies to consider:

Identifying Quality Stocks

During a market downturn, it’s essential to focus on high-quality stocks with strong fundamentals. Look for companies with solid balance sheets, consistent earnings growth, and competitive advantages in their industries. These stocks are more likely to recover and thrive in the long run, making them attractive investments during periods of market distress.

Diversification and Risk Management

Diversification is a key principle of risk management. By spreading your investments across different asset classes, sectors, and geographic regions, you can reduce the impact of any single market event on your overall portfolio. During times of market volatility, a well-diversified portfolio can provide stability and resilience.

i often get asked why my client portfolios hold more than one stock in the same industry. Days like today are the reason why. Some stocks in the industry will be hit harder than others and you never really know which ones an emotional investor will sell to raise capital.

Today, for example, they are selling chip maker Intel to a low that hasn’t been seen in a decade, but chip maker Nvidia is off 6% – still a big loss but investors are selling Intel more strongly.

For some perspective, I don’t own Intel in client portfolios and I sold a bunch of it several weeks ago for client portfolios that were significantly overweight the holding due to it meteoric rise.

Long-Term Focus

Successful investing requires a long-term focus. While short-term market fluctuations can be unsettling, it’s important to stay focused on your long-term investment goals. Avoid making impulsive decisions based on short-term market movements and instead, take advantage of opportunities to buy quality assets at attractive prices.

Conclusion

We will not know if today’s selloff is a short term realignment of the leverages Yen trade or if it is the start of a bigger move down. The markets will be volatile for awhile which is why maintaining sound risk management practices is key to long term success. In June we rebalanced client portfolios back to strategic asset allocation percentages, selling stocks down to their allocation due to equity growth over the year and buying fixed income with the proceeds.

Additionally, we sold underperforming stocks to raise cash and sold down any positions, like Nvidia, that had grown outsized in portfolios.

With this proceeds, we have been accumulating quality holdings with solid earnings growth after material pullbacks during the July and now August sell off.

We added defensive positions in Utilities and Industrial REITs that will move higher with the coming Fed rate cuts.

All in all, our client portfolios are in a good position for long term success. Will they go down during this correction? Of course – that is all part of investing. But the risk management tactics we used will position them for a move higher when all is said and done.

I’ve typed this on my phone so I apologize for any typos you come across.

Thanks for reading and don’t panic.

Mark