What Does $250 Billion Buy? A Carry Trade Blow Up

A new paper published by the Bank for International Settlements (BIS) as part of its Bulletin series, takes an early look at the market upheaval at the start of August, including the carry trade blow up, and concludes that while market structures were resilient, the risks that triggered the mayhem have not receded.

The paper, The Market Turbulence and Carry Trade Unwind of August 2024, authored by Matteo Aquilina, Marco Lombardi, Andreas Schrimpf and Vladyslav Sushko, observes that while it is hard to assess the size of the carry trade unwind, data does exist to provide hints and using estimates based on both on- and off-balance sheet activity it suggests a “rough middle ballpark” figure of $250 billion was involved – it also observes this number is, if anything, lower than the reality due to data gaps.

“The event was yet another example of volatility exacerbated by procyclical deleveraging and margin increases,” the paper states. “Although an outright market dysfunction was averted this time, the structural features of the system underpinning such episodes deserve continued attention by policymakers.”

Interestingly, the authors note that while the largest moves occurred in August, signs of fragility had appeared in early July, when the Japanese yen, a favourite of carry traders, started to reverse from its multi-decade lows against the dollar. They also observe that after that, which was prompted by Bank of Japan intervention in USD/JPY, an equity sell-off on July 24, including a reversal for AI and tech stocks, also provided signs of a carry trade unwind.

When the headline turbulence did hit in August, the authors argue that it was triggered by “seemingly minor news”, a disappointing US labour market data release, that followed a perceived hawkish rate hike by the Bank of Japan and signs of a more cautious path to rate cuts by the Federal Reserve. “Investors appeared to reassess the likelihood of a potential recession, with some perceiving the prevailing policy stance as too tight,” the paper states. “In fact, the news could hardly be taken as an unequivocal sign of a deteriorating outlook, let alone a looming recession. Yet, markets had become hyper-sensitive to any signs of a change in growth momentum and in the associated monetary policy outlook. Thus, the news acted as a catalyst for an equity market correction.”

A number of factors behind the recent turbulence reflect structural features of our financial system, notably the greater heft of market-based finance

The authors suggest that what they term an outsized market reaction to a single data release hints at a key role of amplifying factors, most notably deleveraging pressures amid thin markets. One amplifier was the sheer length of the period of relative stability in markets, which are particular conducive to an increase in leveraged positions such as the carry trade. “In line with this, aggregate market leverage in the US hedge fund sector had been on an upward trajectory in the run-up to the event,” the paper says.

What followed was what could be termed a classic carry trade blow up, indeed the paper notes that as carry strategies tend to generate small but consistent returns at times of market calm, but quickly generate steep losses as turbulence erupts, they are often portrayed as “picking up nickels in front

It also cites, however, evidence that US equity volatility has become closely intertwined with currency carry returns. “This common exposure is due to the fact that many equity option strategies entail implicit bets on volatility being contained, akin to currency carry trades,” the authors write. “Indeed, the market dynamics of 5 August fit with the historical patterns.”

As noted, the paper is quick to point out that the exact size of positions in the carry trade is difficult to estimate, but the authors provide several data points that could be indicators. Net short positions in yen futures by speculative traders reached historical peaks of around $14 billion and were unwound during the event, they observe, whilst noting currency futures are “only the tip of the iceberg”.

OTC FX derivatives are behind much larger carry trade positions, the paper states, adding that a back-of-the-envelope calculation for an upper bound on the size of hedge fund speculative activity with currency forwards yields an estimate of around $160 billion. In addition, the authors point out that there are various other ways to implement carry trades and similar currency bets using off-balance sheet derivatives. For example, an open position in forwards can be rolled using FX swaps, as can currency options, especially when betting on emerging market currencies.

In addition to off-balance sheet (derivatives) positions, the paper says carry trades and broader yen-funded investment strategies can be implemented using on-balance sheet instruments. Estimates of the size of these activities can be gleaned from various forms of yen borrowing from banks by entities located outside Japan, which have nearly doubled since 2021 to almost JPY 14 trillion (or over $90 billion). It adds that BIS Global Liquidity Indicators further show that yen-denominated loans to non-banks resident outside Japan rose markedly after Covid-19, to about ¥40 trillion ($250 billion) by March 2024.

A final aspect in estimating the size of the unwind comes from one of the bigger segments involved in the carry trade – Japanese retail, although the paper does not estimate an amount, it limits itself to observes that a drop in crypto prices at the same time could also have prompted margin calls, leading to the closing of yen FX positions.

A fascinating aspect of the analysis is that while it focuses largely on the yen as a key component (with the Swiss franc) of the carry trade, it observes that the event also involved currencies not previously associated with the strategy, especially the Chinese Renminbi (RMB), which also soared against the dollar.

The factors behind the volatility spike and large market moves have not changed significantly, risk-taking in financial markets remains elevated.

The Malaysian ringgit also rose, by more than the RMB, as it has been seen as a proxy for the latter, more traditionally, higher yielders such as the Mexican peso and South African ran, were hit hardest.

Overall, the authors argue that markets showed “substantial resilience” in the face of considerable volatility, and that the speed of the recovery was “remarkable”, adding, “Despite multiple signs of currency carry trade unwinding, the magnitudes of exchange rate changes were not outsized when compared to past well-known carry crashes, and indicators of FX volatility did not rise nearly as much as those of equities.”

It also observes that trading was orderly across other asset classes, and liquidity conditions, while having deteriorated, still allowed for undisrupted trading. CCPs and their members were able to manage large changes in margins, and public authorities did not need to intervene to restore calm.

“That said, the factors behind the volatility spike and large market moves have not changed “significantly,” the paper states. “Risk-taking in financial markets remains elevated. Only a share of various trades predicated on low volatility and cheap yen funding appear to have been unwound. Some broader trades funded in the yen, potentially involving more illiquid assets, may be unwound more sluggishly.

“Furthermore, there were already indications that some leveraged positions were quickly being rebuilt,” it continues. “More broadly, a number of factors behind the recent turbulence reflect structural features of our financial system, notably the greater heft of market-based finance. Of particular concern are the ones that enable the build-up of large positions in periods of calm and necessitate their quick unwinding when volatility rises. The reliance on leverage for many of these positions implies that investors will have to respond more strongly to adverse shocks to avoid significant losses.

“If such behaviour takes place in a jittery and illiquid market environment, volatility could be further exacerbated, and a negative feedback loop could be kindled,” the authors warn in conclusion. “In addition, sudden (and large) changes in margins from derivatives and securities positions that are not directly linked to trades that rely on low volatility could add further pressure to markets, infrastructures and intermediaries.”

The full paper can be accessed here