Carry On Baggage

Cautious, not Fearful: Our Value-at-Risk measures dropped precipitously on the reversal from the lows, meaning that risk-aversion is a mere afterthought. This is never a welcome situation. We are opening this morning with weakness as traders are lightening up and squaring positions ahead of the employment data at the end of the week. Yen strength since the New York open is not helping the bull case either. Initial Claims and Nonfarm Payroll data are critical because the data will add more color on whether the Fed is behind the curve or not.

Yen Carry Trade: Behind the Curtain

First the easy part—“What” is it? The Japanese Yen carry-trade is easily defined as borrowing in Yen and investing it elsewhere by buying higher-yielding currencies such as the Mexican Peso or South African Rand. Proceeds from shorting the Yen can be put into other rapidly appreciating asset classes, such as U.S. tech stocks. Now to the tricky part:

1.     “How Big” is the trade? It would take too long to tease out the details here, but looking at Yen-denominated cross-border borrowing it appears that about $2 trillion of the trade was put on over the past three years. However, estimates vary because no one knows how much of the lending went into the carry trade.

2.     “How much is left?” It appears that the speculators (macro hedge funds and commodity trading advisors and, of course, retail) have been blown out of the trade. Pensions and asset managers appear to still be in the trade at diminished size. The consensus seems to be that a major part of the yen carry-trade overhang is gone. We can gauge how correct that assumption is on any move to new lows in the Dollar Yen Rate or USDJPY.

Back to another “What”: What does this mean for U.S. investors? If the cycle is heading towards a sustained period of yen strength, global investors should begin adding exposure to Japanese stocks. Looking at the major Yen rallies over the past 30 years, the most recent being 2015-2016, Japanese equity markets have fallen between 5-10%, but on a currency-adjusted basis, U.S. investors made over 20%, thanks to Yen strength. Therefore, If USDJPY falls 20% from here, U.S. investors are looking at potential gains of 10-15%. Even if global markets reverse soon, the Japanese Yen appreciated in 1998-1989, 2002-2004, and 2007-2009 when stocks experienced severe pullbacks. Therefore, it is unsurprising that EWJ, the Japanese MSCI ETF (priced in dollars) has outperformed SPY since the early August Yen carry-trade unwind. 

Call Me by Your Name

I’m sorry, did you just say the Yuan carry trade? It’s not a typo, but we wonder if it’s realistic. Currency strategists are beginning to discuss a latent carry trade within China that could rise to the surface as soon as the Federal Reserve begins cutting rates.

Guan Tao, an economist at Bank of China International, believes that the repatriation risk is real, and Chinese exporters and multinational companies are ready to bring dollar-denominated assets back home when the U.S. interest rate differential shrinks. Repatriation could be large and result in an outsized rise in USDCNY. We are not sure Beijing would be ok with the Yuan jumping strongly—the expectation is a potential double-digit appreciation—because the government is relying on exports to support a floundering domestic economy. However, it is a fact that Chinese institutions have moved a great deal of capital offshore. Like the Yen carry trade, estimates of the size of the Yuan carry trade vary widely. Somewhere between $400 million to $2 trillion has been invested in U.S. assets over the past few years.

Our view is that any such repatriation will be controlled, and if a recession occurs, the dollar should appreciate and the benefit of moving out of U.S. investments would diminish. Additionally, if China’s economy continues to contract, Chinese corporates will prefer to continue to diversify abroad.

If at First You Don’t Succeed

Canada has taken the early lead. Its central bank is expected to cut another 25 basis points this week when they release their Monetary Policy Report Wednesday, bringing their target overnight rate down 75 basis points in their last three meetings. The U.S. should join the Bank of Canada's rate cutting campaign two weeks after its decision. At the beginning of the year, investors expected the Fed to have cut at least four times by now. The Fed’s reluctance to cut has not tempered investor enthusiasm one bit. In fact, quite the opposite. Expectations have reached a record as the market is pricing in eight rate cuts by the September 2025 meeting. To put this in perspective, as growth and inflation began to turn down before the Global Financial Crisis, the futures market forecasted “only” seven rate cuts throughout 2008.

The fastest rate cutting schedule in 35 years seems at odds with a booming stock market. However, we have discussed the potential for the present situation to pattern itself after the 2007 equity market peak, which suggests a significant equity high in the coming weeks that reverses over time. As we look at the similarity between the fed funds futures market then and now, we are looking more closely at the analogy to 2008 (without expecting the severity of 2008’s financial implosion).

What to Look for This Week

1. Labor Data Week: Wednesday, September 4, 10:00 a.m. E.S.T. Job Openings and Labor Turnover (JOLTS) report. Thursday, September 5, 8:15 a.m. E.S.T. ADP National Employment Report followed at 8:30 a.m. E.S.T. Initial and Continuing Claims. Friday, September 6, 8:30 a.m. E.S.T. Employment Situation report, which many are looking for an improvement from the August data.

2. Wednesday, September 4, 7:00 a.m. E.S.T. Mortgage Bankers Association (MBA) Purchase Index. 10-year Treasury yields have been below 4% during August, and 30-year fixed mortgages have fallen from 6.75% to below 6.50% in that period. The Purchase Index has not responded yet, still reflecting weak demand and poor affordability.

3. Wednesday, September 4 9:45 a.m. E.S.T. Bank of Canada (BOC) Interest Rate Decision and Statement. July of last year the BOC raised rates to 5% where they stayed until the June and July 25 basis point cuts. The September meeting is expected to see another 25-basis point cut to 4.25%. Canadian equities have been outperforming the U.S. since those cuts. Will be focusing on the 10:30 a.m. E.S.T. press conference and the Toronto Stock Exchange (TSX) Index.

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