A Deeper Dive Into the Carry Trade

Over the last several days, LPL Research has published an array of publicly available content related to the jump in equity market volatility, including: 

• Thoughts on the Market Selloff 
• Navigating the Storm: Insights on Market Volatility 
• More Pullback Perspective 
• Market Signals Podcast: Bond Market Perspective on the Selloff 
• The Talking Point: Tough Week for Market as Selloff Continues 
• Global Selloff Thoughts and the Dollar's Path to Decompressing

What Happened?  

In short, the recent sell-off was underpinned by three primary factors, including: 1) overbought conditions coming into August — especially in big tech; 2) waning confidence for a soft landing due to last week’s weak Institute of Supply Management (ISM) manufacturing and employment data; and 3) the rapid unwinding of the crowded yen carry trade.   

What Should Investors Do? 

To boil down the conclusion of our research into one simple message, don’t panic. Pullbacks and corrections are quite common, even during a strong bull market. Over the last 70+ years, the S&P 500 has experienced an average maximum peak-to-trough drawdown of 13.7% during a calendar year, suggesting the current 8.5% drawdown is still below average. Volatility also brings opportunity, and forward market returns after sizable drawdowns tend to be above average. Furthermore, it is important to remember the markets long-term uptrend remains intact and most breadth metrics are holding up well. 

What’s Next?  

From a technical perspective, the risk of additional selling pressure appears elevated. Market bottoms are often a process and begin to form after oversold conditions reach extremes — something yet to fully materialize amid the current drawdown. As highlighted in panels two and three below, only around 12% of S&P 500 stocks reached oversold levels based on the Relative Strength Index (RSI), well below readings above 20% that typically overlap with bottoms. The percentage of new four-week lows across the index also failed to trigger a washed-out reading. Based on this backdrop, there is insufficient technical evidence to make the case that a durable bottom has formed.  

In the event of further selling pressure, watch for support at 5,254 (March high), 5,227 (Fibonacci retracement level — Fibonacci retracement levels are lines that indicate where support and resistance are likely), 5,119 (August low), and 5,026 (200-day moving average (dma)). Resistance sets up at 5,312 (price gap/Fibonacci retracement level), 5,321 (May high), 5,347 (price gap), and near 5,400 (July low).  

Volatility measures have been notable and point to abating fear in the market. The CBOE Volatility Index — more commonly called the VIX or ‘fear gauge’ — surged to its highest reading since March 2020 on Monday. Historically, major spikes in the VIX often occur near major capitulation points in equity markets, especially when the curve moves sharply into backwardation (as was the case this week), characterized by spot VIX trading at a premium to longer-term contracts.   

S&P 500: A Relief Rally or a Durable Bottom?

Source: LPL Research, Bloomberg 08/07/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested directly.  

A Closer Examination of the Carry Trade 

Ultra-low rates and easy monetary policy made the yen an attractive funding currency for the carry trade, where investors borrow in currencies with low rates to fund purchases in higher-yielding securities elsewhere. However, recent tightening from the Bank of Japan (BOJ) pulled the proverbial thread on this crowded trade, and it started to unravel over the last few weeks, sparking a surge in yen buying as investors covered short positions.  

As highlighted below, the USD/JPY pulled back through support from its prior highs near 152 and violated its longer-term uptrend. The pair finally found their footing near the December lows (141), where a relief rally off extremely oversold conditions subsequently developed. For context, the RSI indicator reached its lowest level since 1997, a period known as “Asian Contagion” as currency devaluations in the region turned into systemic market risk.  

Determining the size of the carry trade can be challenging due to the opaqueness of currency positioning and transactions. For example, analysts speculate yen carry-trade borrowing could range anywhere from $1 to $4 trillion in total, with recent reports estimating that 75% of carry trades have now been closed. Regardless, the path of least resistance for the USD/JPY is no longer higher, implying risk for additional downside volatility is elevated. Technicals provide a framework for assessing this risk, and a close below support at 141 would point to another potential leg lower for the pair. In contrast, a rally back above 152 would recapture the 200-dma and prior uptrend, suggesting reduced carry trade volatility and downside risk.   

The Dollar/Yen is Also Searching for a Bottom

Source: LPL Research, Bloomberg 08/08/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly. Any futures referenced are being presented as a proxy, not as a recommendation. 

The Commodity Futures Trading Commission (CFTC) provides a more definitive estimate of the overall change in yen short positions. The bottom panel of the chart above highlights combined short yen futures contracts for non-commercial (often hedge funds/large speculators) and non-reportable (generally considered small speculators) traders. While this cohort represents a significantly smaller portion of the aggregate yen carry trade, it can at least be used as a proxy for sentiment and direction of short yen positions. Collectively, this group is currently short 179,000 futures contracts, equivalent to around $15.3 billion in notional dollar terms. To square these positions up to levels where they started the year (127,000 contracts), traders would need to buy back or cover another 52,000 contracts. As you may notice, short yen positions and the USD/JPY are also positively correlated, and a simple regression analysis between weekly changes in short contracts and the USD/JPY suggests an unwinding of yen short positions back to January levels could lead to another 16% decline in the currency pair. While a drop of this magnitude is unlikely, especially given the recent dovish commentary from BOJ Deputy Governor Shinichi Uchida, who suggested they would not raise rates if financial markets were unstable, the data suggests the unwinding of yen short positions could have more room to go.   

Summary 

Stocks have rebounded off their recent lows as better-than-expected economic data recently helped suppress recession risks. While volatility measures point to a potential capitulation point, the degree of shorter-term technical damage and lack of widespread oversold conditions leaves us skeptical of the lows being set. Currency market volatility has also abated as the unwinding of the yen carry trade slowed. However, the dollar/yen is no longer in an uptrend, and it is too early to consider the latest rebound in the pair as anything more than a relief rally off oversold levels. Overall, we remain cautious on a near-term basis until there is sufficient technical evidence of a durable low being set for the S&P 500.