The numbers flashing on the stock screens on Monday were shocking.
- In Tokyo, the Nikkei fell 12%.
- In Seoul, the Kospi sank 9%.
- And when the opening bell rang in New York, the Nasdaq plunged 6% in seconds.
- Cryptocurrencies plunged.
- The VIX, a gauge of stock market volatility, soared and
- investors piled into Treasuries, the safest asset of all.
Whether Monday’s wild swings mark the final blowout of a global sell-off that began to develop last week or mark the beginning of a protracted downturn is impossible to know. Trust Economics is predicting a major crash next fall.
The Nikkei on Monday posted its worst performance since the October 1987 crash as investors were rattled by last week’s plunge in global stock markets, U.S. recession risks and worries about investment financed by a cheap yen.
Recovery in the S&P and Dow Jones are also showing futures, after gains of around one percentage point, while the main European stock markets are also expected to open higher.
The role of the carry trade in global markets
The collapse in global equity markets in recent days reflects more the collapse of so-called carry trades (interest rate arbitrages) that investors use to hedge their bets than a hard and sharp change in the US economic outlook.
Although weaker-than-expected US jobs data was the catalyst for the sell-off in the market, the jobs report alone could not be enough to be the main driver of such violent moves. They have been caught in their net as the Japanese yen has risen more than 11% against the dollar since hitting 38-year lows just a month ago.
Instead, the answer likely lies in the further easing of carry-trades, where investors have borrowed money from low-interest-rate economies like Japan or Switzerland to fund investments in higher-yielding assets elsewhere.
Much of this (market selling) is due to capitulation as some macro funds were caught on the wrong side of a trade and stops were triggered, initially starting with the forex and the Japanese yen and in terms of pre-set market trigger levels or the sale.
Some of the biggest systematic hedge funds, which trade in and out of stocks based on signals from algorithms, began selling shares after the Bank of Japan’s surprise rate hike last week fueled expectations of further tightening.
While the exact numbers and specific position changes underlying the moves are hard to come by, analysts suspect crowded positions in U.S. technology stocks, financed by carry trades, explain why they are suffering the most.
The carry trades, boosted by years of ultra-loose Japanese monetary policy, have fueled a boom in cross-border yen borrowing to finance trades elsewhere.
Data from the Bank for International Settlements suggests that cross-border yen lending has increased by $742 billion since the end of 2021, the bank noted.
The shorties
Speculators have aggressively trimmed bearish bets on the yen in recent weeks, bringing the yen’s net short position to $6.01 billion, the lowest since January, from April’s seven-year high of $14.526 billion.
The biggest carry trade the world has ever seen can’t unfold without some heads breaking.
The blow to hedge funds
As hedge funds typically finance their bets through borrowing, their adjustments exacerbate market movements. It is noted that banks provide leverage to hedge funds, essentially a loan to invest capital, which boosts hedge fund returns, but can also increase losses.
Gross leverage, or the total amount hedge funds have borrowed, fell in June and July but is still near five-year highs.
Last week was the third week in a row that hedge funds’ bets that stocks will fall outpaced new bets for them to rise, with one long position added for every 3.3 short bets.
Since the Asian close, Japan-focused hedge funds have fallen 7.6% in the past three sessions.
But there is room for further near-term pain as positions unwind, but market reversal would be limited.
