One of the more popular trades in recent memory was the yen carry trade (JPY=X), which backfired after the Bank of Japan started a rate hiking cycle. While it resulted in a sell-off on Monday, will traders continue this strategy?
TD Securities global head of FX and EM strategy Mark McCormick joins Catalysts to give insight into the carry trade and movements in global markets
Right out of the gate, McCormick affirms: "I do not think the carry trade unwind is over. I think we have a long way to go. I think you need to think about whether it's kind of tactical and the structural nature of it The structural nature of the carry trade is tha,t for pretty much around the last decade, Japanese investors have put their money, mostly pension funds, which accounts for about 80% of GDP in other markets. So the assets that they're tracking in other markets are actually a big form of the carry trade."
When asked whether the Chinese yuan could be the next carry trade to unwind, McCormick responds: "I think you need to kind of disentangle the correlation of the yuan versus the yen. They have re-correlated right now. They're being driven by similar factors. So the Chinese yuan is a good funding for a carry trade. And again, if you think about what drives a carry trade in markets, why people love it. It's very simple. It's what you need is rate divergence, so one country needs higher rates, another country needs lower rates. And you need low volatility."
ADVERTIsem*nT
For more expert insight and the latest market action, click here to watch this full episode of Catalysts.
This post was written by Nicholas Jacobino
Video transcript
Dollar yen is on track for its first week of gains since June, the unwind of the carry trade that drove part of the market sell off.
We've seen has slowed throughout the week that slowing coming on the heels of better than expected economic data and do commentary from the Bank of Japan.
So the big question, will the slow down of the unwind continue here joining us to discuss.
We got Mark mccormick, he TD security, global head of FX and EM strategy.
Mark Great to have you as always.
So you, you talk about this in your note, you said that the boj pivot has likely ushered in a regime, a regime change for the yen given that, do you think the unwind of the carry trade is over for now?
I do not think the uh carry trade and wind is over.
I think we have a long way to go.
I I think you need to think about whether it's kind of tactical and the structural nature of it.
The structural nature of the carry trade is that for pretty much around the last decade, Japanese investors have put their money, mostly pension funds which accounts for about 80% of GDP in other markets.
So the assets that they're tracking in other markets are actually a big form of the carrier trade.
It's hard to say this is yen specifically, you know, they're betting on higher yields in other, in other places.
But a piece of this carry trade, if you look at the correlation of the NASDAQ to the YEN is the out performance of us equities and probably investments we have in Japanese pension funds into those us equities which have been very strong performers over the last five, 10 years.
So I I think a big piece of the un carry trade is it links together a lot of these different global themes, which is it was very, very easy to fund in yen and it was very easy to find other places around the world that offered higher yield or higher growth.
And now the entire complex around that system is now starting to unwind.
So then mark what kind of adjustments have you made?
Are you advising investors to make if the pain isn't over yet?
We've been talking about this for months like we have pushed back.
I think we had the same conversation probably in in April or May around the goldilocks trade.
To me, this was um you know, you never know the catalyst but the conditions for volatility to rise, I I feel like is not very surprising.
Um I feel like what we're trying to do is piece together what caused this like us data slump thing I would highlight as well that if you look at Chinese data, it's slumping faster than us data and Eurozone data is also declining.
If you look at the uncertainty around the US election or geopolitical uncertainty, we had macro volatility basically setting back to levels that we were in 2021 after the world reopened from the pandemic.
So the levels that we saw in global macro vol versus all the conditions that can change them.
It's always hard to get the precise trigger, right of what causes this thing to unwind.
But for me, it was very clear that the the thing that was going to happen is we're going to have a series of events that markets weren't expecting.
Namely uh we were looking for the the boj to hike in July.
This to me was a function of again that the currencies that are undervalued that are short uh short plays in the Kerry basket or also the currencies that the US administration has called out on being undervalued, whether it be the Korean Wan, whether it be the Japanese yuan, whether it be essentially uh the Japanese Yen, these are all currencies that are fundamentally in value.
So I still think that the the drivers in place is is something that we, we have a long way to go for the carried unwind and, and we're probably in a new regime where again, the goldilocks trade is essentially fallen by the wayside is the Chinese Yen the next carry trade, unwind that investors should look out for.
So that's a great question because I think you need to kind of disentangle the correlation of the yuan versus the yuan.
They have rec correlated right now, they're being driven by similar factors.
So uh the Chinese yuan is a good funding for a carry trade.
And again, if you just think about what drives the carry trade of markets, why people love it?
It's very simple.
It's uh what you need is rate divergence.
So one country needs higher rates, another country needs lower rates and you need low volatility.
So you assume the conditions are not going to change.
Uh That's also what makes it very vulnerable to very violent drawdowns, which is what we've seen.
So what I'd say is the the coupling of the correlation between the Chinese yuan and the Japanese Yen makes sense because they are both funding currencies mechanically as we move uh out of what you would call, say the period of the next couple of weeks and into months and quarter.
I think they're going to probably recouple again because I think they're two undervalued currencies and I think they need to both be stronger.
But I think in the short term, the BOJ is moving in a in a direction that's going to continue to tighten policy.
The Yen is way more undervalued than the Chinese yuan.
And I think a big, big driver here is that Japanese flows uh or pension funds particularly have been pushing money outside of Japan.
They will be bringing money home, they will be resetting their asset allocation targets to buy more JG BS and buy more local equities.
And I don't think you have the same uh capital market mix in, in China.
So I that's where I do think we'll see divergence in the next couple of months as the Yen should outperform the yuan.
But I think if we measure this in terms of like over the next year, over the next two years, they should both be currencies that strengthen relative to the dollar.
