Did Carry Trades Cause The Stock Market Downturn?
Over the past two weeks, choppy trading has dented global stock prices, while safe-haven government bonds have rallied. Concerns over the health of the American economy and the high valuations of tech stocks have certainly contributed to the surge in volatility. However, analysts and investors have pointed to another potential culprit: the unwinding of carry trades.
What is a Carry Trade?
A carry trade involves borrowing money in a low-interest-rate currency and investing it in assets or currencies that offer higher returns. Investors profit from the difference between the cost of borrowing and the return on investment. However, when these trades are unwound quickly—whether due to changing interest rates, rising risk aversion, or a stronger base currency—the sudden liquidation of positions can cause significant volatility in both currency and equity markets.
The Recent Unwind and Its Consequences
Recently, traders had been betting that the interest rate differential between Japan and the United States would remain wide, leading them to borrow yen to invest in U.S. dollars. But in July, Japan raised its interest rates by a fraction of a percentage point, while expectations grew that the Federal Reserve might reduce rates in America. This shift exposed traders to potential losses, forcing them to unwind their carry trades. The rapid unwinding likely contributed to a knock-on effect of forced selling, particularly in American tech stocks, exacerbating the market downturn.
The Hidden Risks of Carry Trades
Despite the growing popularity of carry trades, much remains unknown about their true scale and associated risks. One reason for this is that most foreign currency borrowing isn't reflected on banks' balance sheets; instead, it’s concealed within the broader world of foreign exchange swaps. These contracts are not counted as debt and go unrecorded on the financial institutions' official balance sheets.
This lack of transparency makes it difficult to discern what portion of these swaps represent standard hedging activities versus more speculative trades. Analysts at UBS estimate that the dollar-yen carry trade reached $500 billion at its peak, whereas analysts at JP Morgan Chase place the figure as high as $4 trillion.
The Implications for Market Volatility
The uncertainty surrounding the scale and impact of carry trades complicates efforts to determine their exact role in recent market turbulence. Fortunately, the damage appears to have been limited this time. However, this highlights the need for central banks and regulators to start collecting and publishing data on foreign exchange swaps. Greater transparency would expose riskier elements of these trades and allow investors to better assess how crowded the markets they are entering might be.