By Carolina Mandl and Laura Matthews
NEW YORK (Reuters) – Investors say the aftershocks of a massive carry trade that has reverberated through global financial markets are not yet over, with more set to happen in the coming days, raising the risk of reorganizations in other assets.
The Nasdaq Composite and the S&P 500 narrowed their losses at the close on Monday, ending a violent three-day sell-off, while Tokyo markets recovered from a similar drop in trading on Tuesday.
The sell-off came after a higher-than-expected U.S. unemployment rate on Friday fueled concerns that the U.S. economy was headed for a recession. Worries about the markets were exacerbated by investors unwinding yen-financed trades that had been used for years to finance stock purchases following a surprise interest rate hike by the Bank of Japan last week.
The so-called ‘carry trade’ is often used in currency markets, where investors borrow money from low-interest-rate economies such as Japan or Switzerland to invest in higher-yielding assets elsewhere – this time equities.
Despite the slowing sales, investors worried about more volatility ahead.
“We expect the sell-off to continue for a couple of days because normally these types of… trades are quite large,” said Zhe Shen, head of diversification strategies at TIFF Investment Management. “People were saying, ‘Wait, we’re losing too much money on the tapering. Let’s just hold on and tomorrow we’ll continue to tape.'”
According to Zhe, it will likely take days for this yen-financed trading to fully complete, potentially prolonging the market decline.
“There are still a lot of yen carry trades that need to be completed,” said Ulf Lindahl, CEO of Currency Research Associates, an advisory firm for institutional investors.
Investors are still trying to figure out how big these transactions were and how much of the cheap financing was invested in stocks.
Calculations by hedge fund research firm PivotalPath show that hedge fund strategies most affected by a yen rally are global macro quantitative and managed futures, because they have short exposure to the Japanese currency. A spike in the yen this month would imply a loss of between 1.5% and 2.5% in August for those funds’ indexes, according to the firm’s exposure model.
“It’s very, very difficult to know what the true size of those positions is and how much is hedged and how much isn’t, and therefore how much pressure there is,” said Kathy Jones, chief fixed-income strategist at Schwab. “When you have hedge funds that are leveraged, and maybe derivatives are involved, you get quite a reaction.”
RISK ALTERNATING
Some asset managers or trading strategies have already reduced risk in recent days.
“Momentum has definitely slowed down quite a bit over the last few days, and that’s true across all asset classes,” said Mike Gleason, director of equity alternative strategies at Acadian. “So you have this response mechanism of multiple asset classes reacting in kind.”
Steve Sosnick, chief trader at IBKR Securities Services, said trading Sunday night and into Monday’s open “gave the feeling of forced selling.”
“There was a certain ‘get me out’ feeling in the pre-market and opening trades, but that has since subsided,” Sosnick said.
Hedge funds began to unwind risk about two weeks ago as stocks began to fall. Morgan Stanley estimated on June 25 that macro hedge funds could sell $110 billion in the coming weeks if markets deteriorate further.
For some investors, the fact that the Nasdaq fell 10% below its record high of 18,647.45 on July 10 poses an additional challenge to a quick and sustainable recovery.
“Most people haven’t pulled back yet because they think it’s just a normal correction,” said Lindahl of Currency Research Associates. “This is serious business, it’s not just a normal correction. You don’t have gap openings of 4% or 5% in major indexes and then they recover. There’s a serious collapse coming.”
US index futures opened positive on Monday evening, suggesting investors are taking advantage of lower valuations.
“We’re seeing a fair number of people looking to become buyers on this downturn. I think we’re probably going to have more of a two-way market because of that,” Schwab’s Jones said.
(Reporting by Carolina Mandl and Laura Matthews in New York; Editing by Megan Davies and Shri Navaratnam)
