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“The road to hell is paved with positive carry.” – A common trading aphorism
Following the global whiplash caused by the Japanese yen carry trade unwind in early August, I want to offer an interpretation of what happened and why market participants are likely underestimating how foreign ownership of US assets could constrain the pace and magnitude of the Federal Reserve’s (Fed’s) rate-cutting cycle.
One of the most interesting aspects of the event is how unusual it was. Typically, currency carry trades refer to situations where investors are long high-carry currencies like those from emerging markets (EMs) and short funding currencies from developed markets — including the Japanese yen. When these trends reverse, we tend to see outsized reactions among and across the various pairwise trades. Some of that did occur here, with the Mexican peso and Australian dollar depreciating rapidly versus the yen, but most high-carrying EM currencies held up, and EM rates rallied despite the sudden risk-off tone and increase in volatility. The most dramatic carry trade unwinds happened among US momentum stocks, hardly the reaction investors would normally expect.
While the delayed release of a hotly anticipated AI chip from market leader Nvidia may have been a factor in the market response, US momentum stocks were selling off before that information came out. So why would Nasdaq performance be correlated at all with an interest-rate decision from the Bank of Japan (BOJ)? And why would the sell-off only abate when the BOJ pushed back on further hikes?
To understand the relationship, it is worth delving a bit into balance of payments (BOP) accounting, a measure of intranational economic transactions. Gross domestic product (GDP) measures the amount of goods and services an economy produces each year. If an economy has more (or less) demand for the goods and services it produces, then it needs to import (or export) these things from abroad. This is referred to as a current account deficit (or surplus). The US demands more goods and services than it produces each year and has a current account deficit of approximately 3.25% of GDP.
If a country, including the US, wants to spend more than it earns, it finances that spending through its financial account. The current account and the financial account are on opposite sides of the ledger, so to speak, so if a country has a current account deficit, it has a financial account surplus, and vice versa. In aggregate, the global BOP (measuring both current accounts and financial accounts) nets to zero. That is to say, for every borrower there is a corresponding lender, and the total of all deficits and surpluses balances to zero.
The US has run persistent current account deficits since 1982. The accumulation of these deficits is referred to as the net international investment position (NIIP). As of the end of 1Q24, the US NIIP was approximately US$21 trillion, or 70% of GDP. Put another way, foreign holders own US$21 trillion of US assets. This, in itself, is not a problem. Many countries, notably EMs, lack the internal resources to make the productivity enhancements they need to develop. As a result, they often run current account deficits to finance investment. In contrast, the US has run current account deficits primarily to finance elevated consumption, which has led to exceptional US growth relative to the rest of the world.
Figure 1
This brings us to the recent yen carry trade unwind. Japan has run consistent current account surpluses with the US for decades, meaning it has a financial account deficit through its lending to the US government and corporations. Japanese investors have used accumulated dollars to buy US equities and bonds, mostly on an unhedged basis in recent years. Investors have been willing to assume the currency risk because the yen has depreciated for many years and the BOJ has kept policy rates extremely low. When the BOJ hiked rates in early August and announced a gradual tapering of its quantitative easing program, the trajectory of the Japanese yen changed overnight. Japanese investors and hedge funds that were short Japanese yen sold their most appreciated asset: US momentum stocks.
Capping the oddity of recent events, US Treasury yields sank and did not rise following the unwinding. This is not as obvious as it sounds. In the last carry trade unwind of March 2020, US Treasury yields initially spiked as foreign sellers scrambled to raise cash in US dollars. That did not happen this time, which implies that Japanese investors were not selling their US bonds, but rather putting on currency hedges in case the yen continued to appreciate.
The US dollar cannot be too strong nor too weak
In the last eight years, problems have arisen each time the US dollar surged (February 2016, March 2020, and October 2022). When foreigners were forced to raise US dollars during liquidity events, they sold what they had, which was (and still is) largely US bonds and equities. The recent yen carry trade unwind illustrates the risks of an overly weak US dollar as well. If foreign investors think the dollar will weaken substantially, they will also sell what they have, which is, again, US equities and bonds; and they will quickly sell US dollars to cover their unhedged holdings.
The Fed likely cannot ease as much as we think it will
In my last piece, I posited a few reasons why the Fed is unlikely to cut interest rates as much as consensus. Here’s one more. If the Fed must worry about foreign selling of US assets amid dollar depreciation, then it cannot ease as much as markets are currently pricing, even if growth decelerates. I believe one of the reasons why the US equity market quickly returned to its highs following the initial few days of volatility is because the market is pricing in 205 basis points of interest-rate cuts over the next year — basically one cut per Fed meeting. If those cuts are realized, global interest-rate differentials would narrow, potentially causing the US dollar to depreciate. This could trigger foreign sales of US assets that would tighten financial conditions, yet the Fed might be constrained from easing further, given negative implications for the dollar.
The real market impact might depend more on the euro than the yen
Although it is the Japanese yen carry trade that has dominated headlines, the much larger holder of US assets is Europe (particularly Germany). Euro area nations have run persistent current account surpluses with the US for the last 15 years. Like Japan, most of these surpluses have gone into US fixed income (particularly credit), some on an unhedged basis. If the euro starts to meaningfully appreciate, holders of US assets will be forced to either hedge their positions (buying more euros and selling more dollars) or sell their US-dollar-denominated assets.
Further yen appreciation could cause domestic investors to sell US fixed income
Without getting too much in the weeds, differences in domestic policy rates make it extremely unattractive for Japanese investors to buy US Treasuries and hedge the currency risk back to yen. For example, if a Japanese investor were to buy a 10-year Treasury today and hedges out the currency risk, they would get a -1.57% yield, obviously much lower than they could earn by buying domestic bonds. The August move was so violent that Japanese investors, I believe, simply hedged their currency exposure temporarily rather than sell their US bonds. If the yen trend has fundamentally shifted, then Japanese investors may eventually sell their US bonds in favor of Japanese bonds.
The Mag 7 should be added to the Fama-French model for asset prices
I am joking, although this has probably already happened via the equity momentum factor. I will explain. An unappreciated reflexivity has materialized over the past 14 years. The US has overconsumed, largely due to government spending. This has elevated corporate profits, most of which have accrued to the highly productive tech sector. Overconsumption has sustained both the US current account deficit and a strongly negative NIIP. At the same time, US equity momentum has generated substantial inflows into both US equities and fixed income, keeping the US dollar strong and encouraging foreign holders to remain unhedged. While I do not believe this trend will reverse per se, I would highlight the increasing importance of US equity momentum to most global asset prices. As fixed income investors, we tend to think that the most important asset price in the world is the yield on the 10-year Treasury, but perhaps we should be trying to figure out the direction of US large-cap tech stocks.
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Toshiki Izumi, CFA, CMA