Pedestrians walk past a currency exchange office in central Tokyo on April 17, 2024.
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According to economists at TS Lombard, a rapid cut in interest rates by the Federal Reserve could worsen the situation in terms of unwinding the global carry trade.
The warning comes as market participants seek to aggressively reduce carry trades following a dramatic global sell-off in risk assets.
Carry trades are transactions in which an investor borrows in a low-interest-yielding currency, such as the Japanese yen, and reinvests the proceeds in higher-yielding assets elsewhere. This trading strategy has been hugely popular in recent years.
European stock markets were roiled on Tuesday, paring earlier gains amid fragile relief.
The stock market plunge in August was partly due to the release of weaker-than-expected U.S. economic data late last week, which led investors to worry that the Federal Reserve was late in cutting interest rates to avoid a recession.
“The Fed’s natural reaction to disappointing labor market data and renewed recession risks would be to cut rates and to do so relatively quickly. But that would exacerbate any unwinding of the carry trade,” TS Lombard economists said in a research note published Monday.
“The US economy should take precedence over everything else, but it would make sense for central bankers to be cautious,” they added.
“Triple whammy”
Led by Freya Beamish, economists at the investment strategy research firm said they hoped to see a coordinated message from the Bank of Japan and the Fed to calm market nerves.
“If the unwinding of carry trades is indeed a problem, we hope these central banks will take steps to introduce some form of quantitative easing that would help prevent Japanese and other investors who rushed into yen carry trades from having to sell assets, and would facilitate a timely Fed rate cut without exacerbating financial fragilities,” TS Lombard economists said.
A Federal Reserve spokesperson declined to comment when contacted by CNBC on Tuesday.
Traditional safe-haven assets, such as the yen and the Swiss franc, surged on Monday, fueling speculation that investors were looking to quickly unload profitable carry trades to cover losses elsewhere.
The Japanese currency has gained sharply against the US dollar in recent weeks, trading at 144.52 yen per dollar as of 2:35 p.m. London time on Tuesday. That contrasts sharply with the run-up to the July 4 holiday in the United States, when the yen fell to 161.96 yen per dollar for the first time since December 1986.
HSBC strategists said there had been essentially a “triple whammy” of concerns in recent days, citing the unwinding of carry trades, the monetisation of artificial intelligence and the prospect of a looming US recession.
The Japanese national flag is seen at the Bank of Japan (BoJ) headquarters in Tokyo on July 31, 2024. The Bank of Japan raised its main interest rate on July 31 for only the second time in 17 years, moving away from its massive monetary easing program.
Kazuhiro Nogi | Afp | Getty Images
“We believe it is still too early to buy, but fundamentals remain broadly supportive,” HSBC strategists said in a research note published Tuesday.
“We believe the biggest risk today is a self-fueling sell-off that ultimately triggers a recession, given the negative wealth effects and tighter credit conditions,” they added.
“Awakened with Vengeance”
Kit Juckes, chief foreign exchange strategist at Societe Generale, said in a recent research note that “the great carry unwind is underway.”
“You can’t unwind the biggest carry trade the world has ever seen without breaking a few heads. That’s the impression we’re getting from the markets this morning,” Juckes said Monday.
According to Mr Juckes, the main reaction from the foreign exchange market continues to be one of “reduction of positions”. He said long positions against the Japanese yen for the Australian dollar, sterling, Norwegian krone and US dollar have all been eliminated.
A fall in the Japanese yen below $140 in the near term “would be unsustainable given the impact on stocks and inflation,” he added.
Economists at TS Lombard said on Monday that global assets – from the US to China – “appear exposed”.
“The external balance sheet maturity mismatch, built up over years of excessive BoJ easing, caused Japanese investors to shy away from foreign assets as the curve flattened at the onset of the pandemic,” they continued.
“But the monetary divergence since the Fed began raising rates has presented a new opportunity: the old carry trade has reawakened with a vengeance.”
—CNBC’s Michael Bloom contributed to this report.
