The global carry trade that crushed markets last month is still a risk, market veteran says

The carry trade unwind that rocked markets last month remains a threat, Ed Yardeni wrote in a note on Sunday.

To the market veteran, last week’s 4.3% slump in the S&P 500 doesn’t make much sense when the Federal Reserve is ready to ease monetary policy. Instead, another factor is likely at play.

“Why are stock prices falling when the Fed is set to lower interest rates to avert a recession and to stop the unemployment rate from rising by boosting economic growth? We had a glimpse of the answer in early August: The carry trade is still unwinding,” Yardeni wrote.

The popular trade has seen investors borrow cheaply in the Japanese yen over recent years, taking advantage of the country’s ultra-low interest rates. These funds were then redeployed into higher-yielding assets, especially US tech stocks, Yardeni said.

But the carry trade buckles when Japan tightens rates, as it did in August. A surprise 15 basis point hike forced traders to sell assets to cover margin calls, contributing to a dramatic US stock plunge on August 5th.

Although the market has since recouped its losses, benchmark indexes tumbled once again in the first week of September, wit the S&P 500 notching its largest weekly decline since the collapse of Silicon Valley Bank in March 2023.

Blame has chiefly fallen on last week’s jobs report, as labor weakness has triggered recessionary fears. But while Friday’s data release was weaker than hoped, the headline number only slightly missed estimates and the unemployment rate ticked down.

In Yardeni’s view, the reaction to the data is a passing growth scare.

“Our assessment of Friday’s employment report is that it wasn’t as bad as widely believed. Furthermore, some of the apparent weakness in employment suggests that productivity growth may continue to surprise to the upside,” Yardeni said in a separate note.

In this context, another factor contributed to the most recent sell-off, Yarden said: hawkish interest rate comments from Bank of Japan Governor Kazuo Ueda.

On Tuesday, the governor confirmed that interest rates will keep rising in Japan if the country’s economy and prices remain in line with the bank’s expectations, Bloomberg said. That day, the yen strengthened against the US dollar.

“Japan’s short-term rates are still very low. If the economy is in healthy condition, they will move up to levels we consider neutral,” Ueda also said two weeks ago, during a parliamentary hearing.

Immediately after August’s carry trade sell-off, JPMorgan similarly warned investors that the unwinding is only half done.