Market Brief - August 2024

With the Federal Reserve holding interest rates steady on Wednesday, the markets began looking forward to any reason for the Fed to join the party and cut rates. Truth be told, central banks have been playing with fire for far too long. A slightly weak unemployment print in the United States on Friday increased volatility but also triggered the unwinding of two leveraged “carry trades”; The Japanese Yen carry trade and the short volatility trade. Both are complex trades mostly employed by large leveraged players such as hedge funds.

The easiest way to understand a “carry trade” is to explain this from something we are all familiar with, insurance. Insurance companies are built on carry trades. That is, they take in consistent income by receiving insurance premiums and occasionally experience large losses due to weather events such as a hurricanes. As an owner of a property and casualty insurance company in Southwest Florida, I am all too familiar with how this “carry trade” can go wrong. In the past 5 years, Florida has lost a dozen insurance companies to bankruptcy due to two strong hurricanes (Irma and Ian), excessive lawsuits, and rampant fraud. It’s been a tough environment for homeowners insurance companies in our neck of the woods. 

The carry trade strategy is most common in currency markets. Let’s look at an example with the Japanese currency, the Yen.

Japanese Yen Carry Trade Example - A hedge fund employs the following strategy:

1. Borrows money in Japanese Yen at rates near 0%.
2. Invests the borrowed capital in a higher-yielding asset such as US Treasury Bills paying 5%.

The return comes from two sources:

1. The difference between the interest cost on the Yen loan (near zero) and US T-Bills (5%). In this example, let’s use 5% as the “carry” return.
2. The second source comes from the exchange rate differential. If the US dollar appreciates vs. the Yen, returns are amplified. The reverse is also true. If the Yen strengthens vs. the US dollar, returns are hampered.

Note most of these strategies employ a large amount of leverage (debt) to amplify returns. This adds to volatility, especially when carry trades reverse. With Japan keeping interest rates very low for many years and other central banks raising interest rates, this trade has been wildly successful. However, what occurs commonly in carry trades is that once a trade outperforms, more investors pile in causing a self-reinforcing collapse when the trade reverses. 

Over the past few weeks, Japan has moved to defend its depreciating currency, raised short-term rates, and started a quantitative tightening program. As seen below, this dramatically increased the Yen relative to the US Dollar. The USD/JPY cross moved from 162 to 145. Every 1 US dollar is exchanged for 162 yen. After the move, 1 USD would only fetch 145 yen. Thus, the yen strengthened.

Figure 1: Japanese Yen (1-Yr Chart)

Created with TradingView

Due to the large amounts of leverage employed, this a recipe for those in this trade to “unwind” and abandon ship. This caused many to sell US dollar assets, exchanging USD for yen and paying off the yen loan. What’s even more interesting is when you look at the USD/JPY and the Nasdaq 100 QQQ ETF (orange line) on the same chart, see below. The QQQ tracks large technology stocks in the United States. The correlation is striking, causing me to think that many in this trade were not buying boring T-Bills, but rather high-flying technology stocks. This explains part of the selloff in the stock market.

Figure 2: Japanese Yen + QQQ (1-Yr Chart)

Created with TradingView

And finally, a large strengthening in the Yen relative to the Dollar has absolutely crushed the Japanese stock market, figure 3 below. Japanese companies are heavy exporters of goods to the rest of the world, so a strong Yen hurts their competitiveness.

Figure 3: Japanese Nikkei Stocks

Created with TradingView

Short Volatility Trade

The second trade affecting markets is the “short volatility trade”. Think back to the example of selling insurance and collecting premiums. The investor that sells volatility receives consistent income from the buyer in hopes that the market, such as the S&P 500 remains calm. Bull markets tend to last much longer than bear markets which can be sudden and sharp. This typically makes this trade profitable. What’s even more interesting again is that some of the same investors that employ a short vol trade, also use the proceeds to buy volatility on the same tech stocks. Again, leverage is used, and this amplifies returns. This trade works, until, well, it doesn’t. When the markets go crazy and volatility heats up, both trades go south and many of these traders unwind positions causing another self-reinforcing cycle and exacerbating risks to the downside.

Diversification

It’s not uncommon for markets to experience higher levels of volatility like this at times. For long-term investors, this noise can be ignored. These are the times when diversification pays off. Assets such as cash, gold, and bonds tend to hold up well. True to its form, gold continues to hold up nicely closing at $2,442, the highest-ever weekly close. Year to date, gold has outperformed stocks. I expect volatility to remain as conditions were ripe in recent weeks with many technical factors pointing to a correction. We’re also dealing with political tensions, elections looming, wars in the Middle East & Russia, and high leverage levels.

Buffett Raises Cash

In other market news, Warren Buffet’s Berkshire Hathaway disclosed recently that its cash levels are at a record level close to $300 billion, while they’ve been active sellers of stocks. “Cash” for Mr. Buffett is typically US Treasury Bills. Buffett is famous for holding large amounts of cash when markets have rallied. He’s also trimming his winners. It also signals what I’ve been writing about, short-term bonds remain attractive.

Figure 4: Berkshire Hathaway Cash & Stock Sales

Source: zerohedge

Bonds

In the bond market, interest rates dropped dramatically last week as investors started to price in various amounts of interest rate cuts by the Federal Reserve. I think the market overreacted to one economic data point and the move in the bond market was a bit overdone last week. We’ll see how markets react looking forward as some of the action on Friday was a classic rush to safe-haven US Treasuries. The chart below indicates the fixed-income market expects around four interest rate cuts of 0.25% over the next 12 months. If the stock market volatility increases beyond control, the Fed may have to come to the rescue and cut rates ahead of the September meeting which is a full 6 weeks away.

Figure 5: Policy Rate Cuts & Forward GDP

Source: CrossBorder Capital

Quote of the Month

“In addition to magnifying losses as well as gains, leverage carries an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin” Howard Marks

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