Market Analysis

A recent meltdown in global equity markets is more indicative of investors unwinding carry trades rather than a significant shift in the U.S. economic outlook, according to analysts.

The market sell-off was triggered by Friday's weaker-than-expected U.S. jobs data, with Japan's Nikkei index experiencing its largest one-day drop since the 1987 Black Monday crash on Monday. However, analysts believe the employment report alone wasn't sufficient to cause such extreme market movements.

The primary factor appears to be a substantial unwinding of carry trades. Investors have borrowed funds from low-interest-rate economies like Japan or Switzerland to invest in higher-yielding assets. These investors faced losses as the Japanese yen appreciated by more than 11% against the dollar from 38-year lows reached just a month prior.

Mark Dowding, chief investment officer at BlueBay Asset Management, noted, "A significant part of this sell-off is due to position capitulation, where macro funds have been caught off-guard, triggering stop-loss orders, especially in the FX and Japanese yen markets. We don't see data suggesting an imminent hard landing for the economy."

An anonymous Asian-based investor mentioned that systematic hedge funds, which rely on algorithmic trading signals, began offloading equities following the Bank of Japan's unexpected rate hike last week, leading to expectations of further tightening.

Analysts suspect that heavily crowded positions in U.S. tech stocks, funded by carry trades, are why these stocks are suffering the most. By 1423 GMT on Monday, the tech-focused Nasdaq index had fallen over 8% in August, compared to a 6% drop in the broader S&P index.

Years of ultra-easy Japanese monetary policy had fueled a surge in cross-border yen borrowing for carry trades, noted ING. Data from the Bank for International Settlements indicates that cross-border yen borrowing has risen by $742 billion since the end of 2021.

Tim Graf, head of macro strategy for Europe at State Street Global Markets, said, "It's a yen-funded carry unwind and Japanese stock unwind. Our metrics show investors were overweight Japanese stocks and underweight yen. They’re no longer underweight yen."

Recent data from the U.S. markets regulator shows speculators have significantly reduced their bearish bets against the yen, bringing net short positions to $6.01 billion, the smallest since January, down from April's seven-year high of $14.526 billion.

Societe Generale's chief currency strategist, Kit Juckes, remarked, "You can't unwind the biggest carry trade the world has ever seen without breaking a few heads."

HEDGE FUND PAIN

Hedge funds, which often borrow to fund their investments, are exacerbating market volatility through their adjustments. Banks provide leverage to hedge funds, amplifying both returns and potential losses.

Goldman Sachs noted that gross leverage from its prime brokerage, representing the total amount hedge funds have borrowed, declined in June and July but remains near five-year highs. Last week, hedge funds added more short bets than long positions, with one long position for every 3.3 short bets.

Goldman added that Japan-focused hedge funds were down 7.6% in the past three trading sessions. Regulatory constraints on short selling in South Korea and China had led many hedge funds to focus on Japan.

Analysts believe there may be further short-term pain as positions are unwound but expect the overall market disruption to be limited. Traders are now anticipating over 120 basis points of U.S. rate cuts by the end of the year, compared to around 50 basis points at the start of last week, with a substantial 50 basis point rate cut expected in September.

Upcoming data might indicate the U.S. economy could avoid a hard landing, making the current market narrative an overreaction. "It's premature to fundamentally reassess the outlook based on recent price action," said BlueBay's Dowding.

Paraphrasing text from "Reuters" all rights reserved by the original author.