As forex markets await political shocks, one tipping point could lead to a ‘catastrophic trade’ that unwinds markets

The foreign exchange market has been eerily quiet since the yen carry trade unwind.

The realized volatility in most currency pairings is incredibly low. But if you look at the backdrop of what’s happening around the world, including geopolitical instability, interest-rate changes, and election uncertainty, FX should be going crazy at this stage, says David Barrett, the CEO of EBC Financial Group, a multi-asset broker.

The foreign exchange market has three major participants, and none of them is making big moves now, he noted. The first is on the surface layer, where short-term traders are betting on currency shifts and yields, which have taken over more volume than historically. On the second layer, you have more speculative traders, mostly made up of hedge funds and trading firms. And on the third layer, you have bigger money, where the pension funds and government allocators sit.

Short-term traders generally don’t affect market direction as steeply. They are in-and-out traders. Much of the moves from the yen carry unwinding witnessed in August happened at this layer, Barrett said. The hedge funds or larger market makers tend to respond to flows that are coming through, making them neutrally positioned based on those flows.

The last group, where the big money pension funds sit, trades foreign exchange for two main reasons: one, they allocate non-denominated currencies for their investments. Two, they hedge their currency exposure to remain neutral. They mainly readjust that hedge when currency rates move. And because we have not seen a huge amount of volatility in most pairs, they have been very quiet, he said.

But the yen could once again shake up an otherwise boring currency market and more.

In August, the US stock market saw a swift pullback (and recovery) after the Bank of Japan raised rates. Japan’s near-zero interest rates had made the yen a funding currency that was borrowed cheaply to invest in other assets where rates were higher — the so-called carry trade. When rates rose and the currency strengthened, the trade unwound.

But what we’ve seen in the yen carry trade is only the beginning, Barrett said. We have flushed out the short-term positions. However, any significant move in the dollar, such as weakness due to interest rate cuts against a strengthening yen, would unravel deeper positions where pension funds sit.

The big talking point in that trade is the Japanese pension fund, Barrett said. It has extensive exposure outside of Japan, and a strengthening yen is very problematic for it. Japan has the world’s largest government pension fund with $1.6 trillion in assets, and a large amount of that is invested outside the country. The pension invests in foreign stocks, foreign bonds, and foreign commodities.

“Now, you may not think that’s a yen carry trade, but it’s absolutely the purest yen carry trade because all of that pension fund money started off as yen,” Barrett said. “It’s been sold, and it’s been put into other investments abroad.”

The shift away from foreign asset interest has already begun. So far this year, Japanese investors bought $192 billion in Japanese government government bonds, the most in at least 14 years, according to Bloomberg. Meanwhile, they cut their foreign bond purchases by almost half, the article noted.

It’s hard to pinpoint an exact tipping point at which things could further unravel, Barrett noted, because positions are built on many layers. For example, hedge funds that are on the second layer that sold yen for the dollar and took positions in Big Tech, like Nvidia, are still in the money in terms of gains. Therefore, these positions may not need further shifts before they move, he noted.

What’s the impact of US elections on foreign exchange trades? There isn’t one, he noted. This is because the race is too tight to predict an outcome at this point.

“So, what you tend to see at the moment is people that have existing risk that are wargaming for what happens if you get a Harris presidential victory or a Trump one,” David said.

The Harris trade is easier to maneuver because it’s expected to be less volatile. There’s a good chance that the same policies will remain in place over the first six to 12 months of her presidency. The market won’t have many new adjustments to make, he noted.

The potential volatility comes from the Trump trade due to tariff hikes, a fiscal boost, higher yields, and probably a stronger dollar that will benefit some sectors more than others, he noted.

“The trades that are being put on at the moment are probably more likely to be the longer-term guys that have ingrained exposure in their portfolio, and they’re putting on some kind of hedge,” Barrett said. “So most people that I talk to in the interbank market are telling me that the options market is busier than the spot market. The options market is something that gives people optionality to react rather than having to be heavily positioned.”

Since the market has generally been long the dollar due to higher rates, most of the options trades would be hedging against a dropping dollar by buying puts, which increase in value if the dollar declines, or doing straddles or strangles, which is when you buy calls and puts at the same or different strike prices. And because volatility in the price of FX optionality is still low, hedges are relatively cheap, he added.