The End of the Carry Trade Spells Doom for US Stocks?

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Sam Meredith of CNBC reports on whether it's the end of the ‘carry trade’ and if Japan’s yen could be ripping through US stocks:

The key driver of global markets is the yen exchange rate, according to one financial historian, who warned the trend should concern those “entirely focused on U.S. domestic dynamics in trying to assess price outcomes.”

Russell Napier, co-founder of the investment research portal ERIC, said in a recent installment of his “Solid Ground” macro strategy report that investors have been provided with a glimpse of the impact that a change in Japanese monetary policy can have on U.S. financial markets.

“That there is such a strong relationship between the structure of monetary policy in China and Japan and US assets prices will come as a huge shock for most US investors,” Napier said in a report published Tuesday.

“The narrative for the past few decades is that the US is, in economic and financial terms, an island largely un-impacted by such global trends.”

Stocks are experiencing a broad slump, with many market participants caught off guard by the speed of the yen’s rally.

The Japanese currency is up around 8% against the U.S. dollar over the last month, trading at 148.84 a dollar on Friday. It marks a stark contrast from the run-up to the July 4th U.S. holiday, when the yen fell to 161.96 per dollar for the first time since December 1986.

The rising yen has fueled speculation about whether this could mark the end of the popular so-called “carry trade” — wherein an investor borrows in a currency with low interest rates, such as the yen, and reinvests the proceeds in a currency with a higher rate of return.

“The now evident vulnerability of US equity prices to a rise in the Yen exchange rate warns of the consequences for US asset prices and developed-world asset prices in general from monetary policy changes in the east,” Napier said in the Tuesday report.

He cited the recent rally in the Japanese currency as an example where selling pressure from investors seeking to repay their yen debt had pushed prices of U.S. equities down, while yields on U.S. government debt continued to decline.

“That the US equity market should react so negatively to this rally in the Yen is the shape of things to come, and an indicator to investors of how inter-related US equity valuations are with the global monetary system,” Napier said.

‘An implosion of the carry trade’

U.S. stocks kicked off the month sharply lower, as fresh data prompted fears of a worsening economic outlook. The weak data led investors to worry that the Federal Reserve may be behind the curve in cutting interest rates to fend off a recession.

The Dow Jones Industrial Average on Thursday fell nearly 500 points, or 1.2%, while the S&P 500 shed 1.4% and the Nasdaq Composite slipped 2.3%.

Cedric Chehab, global head of country risk at research firm BMI, said Friday that a combination of factors have been at play over the past roughly 10 day-period. However, he insisted “corrections like this are absolutely normal” at this time of year.

“First of all, the hawkish Bank of Japan caused an implosion of the carry trade over a short-term basis. We also had bad manufacturing data out of the U.S. and some employment sub-indicators which scared markets,” Chehab told CNBC’s “Street Signs Asia” on Friday.

“And then overnight, we saw a lot of volatility in some of the major earnings. And all of that helps push equity markets, which had been quite expensive, even lower,” he continued.

Chehab said one factor that some investors appeared to be forgetting was that there is typically a seasonal rise in equity market volatility over the July-October period.

‘Early warning indicator’

Separately, Napier said that a recent downturn in U.S. equities was likely to have significant ramifications for yen carry-trade investors.

“This negative reaction of US equity prices will be exacerbated in a financial repression as the carry trade investors will be forced to sell at the same time as Japan’s financial institutions are forced to sell to purchase [Japanese government bonds] as directed by the Japanese authorities,” Napier said.

“With the Yen so undervalued and the need for financial repression in Japan now imminent, investors should not expect US equity valuations to continue to rise when this change comes.”

Napier concluded that the moves in the yen exchange rate in recent weeks and the impact on U.S. equity prices “provides some early warning indicator of the scale of the difficulty for the US in sustaining the unsustainable when foreign investors enter a period of capital repatriation to a home bias which will likely last over a decade.”

Alright, it's Friday, August 2nd but it feels like Friday the 13th in markets as stocks continue to sell off hard this week.

I'll come back to the "end of the carry trade" below.

The truth is there are a bunch of macro currents going on but suffice to say that there's a global RISK OFF trade going on since last Wednesday, a week before the Fed delivered its monetary policy statement this Wednesday stating it is leaving rates unchanged but assessing whether to start cutting rates at its next meeting in September.

Today's disappointing jobs report sends an unmistakable message to the Fed to start cutting rates next month:

Expectations heading into this morning showed projections of about 185,000 new jobs having been added in the United States in July. As it turns out, according to the new report from the Bureau of Labor Statistics, the job market didn’t fare quite that well. CNBC reported:

Job growth in the U.S. slowed much more than expected during July and the unemployment rate ticked higher, the Labor Department reported Friday. Nonfarm payrolls grew by just 114,000 for the month, down from the downwardly revised 179,000 in June and below the Dow Jones estimate for 185,000. The unemployment rate edged higher to 4.3%, its highest since October 2021.

The jump in the unemployment rate was especially notable: In July 2023, the rate was 3.5%, and 12 months later, it’s 4.3%. It’s why the public is about to hear a lot about the “Sahm Rule.”

But as the public digests the latest figures, it’s worth emphasizing that the Federal Reserve, hoping to combat inflation, kept interest rates high, knowing it would cool the job market. The recent slowdown, in other words, isn’t an accident; it’s a deliberate outcome of the Fed’s strategy.

It’s also why the obvious reaction to today’s jobs report will be renewed pressure on the Federal Reserve for a meaningful rate cut in September — at the latest.

What does all this mean? First, it means the lagged effects of the rate hikes are finally cooling the US economy and recession has arrived.

That's the real reason stocks are selling off because recessions aren't good for earnings and there is a rotational shift away from growth assets to defensive assets.

Since late April, long bonds have rallied as growth fears dominate, sending yields a lot lower. But the real rally has happened in the last week at the 10-year Treasury yield declined from 4.25% to 3.8%:

 

And the short end of the curve rallied even more as traders bet a Fed rate cut is imminent next month:

That's what you'd expect as we approach the day where the Fed actually starts cutting rates.

What do Fed rate cuts mean for stocks? Unfortunately, not good.

Stocks are likely to fall when the Federal Reserve delivers its first interest-rate cut because the pivot will come as data signal a hard — rather than soft — landing for the US economy, according to Bank of America Corp.’s Michael Hartnett:

In the history of the start to Fed easing since 1970, cuts in response to a downturn have proved negative for stocks and positive for bonds, the BofA strategist wrote in a note, citing seven examples that demonstrated this pattern. “One very important difference in 2024 is extreme degree to which risk assets have front-run Fed cuts,” Hartnett said.

The equity market is already showing signs of weakness as investors grow more convinced that the US central bank will have to ease rapidly in the second half. That pullback has stoked volatility in equity markets, with the CBOE Volatility Index spiking above a key 20 level for only the second time in 2024.

As shown below, the CBOE Volatility Index (VIX) -- a measure of market fear -- hit a high of 29.66 earlier today and then settled lower at 25 as vol sellers came in:

In terms capitalization, small-caps bore the brunt of the selloff this week, declining 8% after peaking on Wednesday afternoon right after the Fed delivered its message:

The selloff in small-caps isn't surprising since they are the most economic sensitive group but in my opinion, it's a bit overdone here and I wouldn't be surprised if we see a bounce next week:

As far as the Nasdaq, it too will likely bounce next week after a steep selloff over the last seven trading days:

But it's important to note, these are counter-trend rallies (bounces) and in a recession, stocks can fall a lot further before finding their footing.

As an example, look at shares of Intel today, down 27% and hitting a new 10-year low:

Stocks are risk assets by definition, they do well over the very long run as economies grow but they get clobbered when a recession strikes.

And nobody knows how long the next bear market will last but since the Fed dragged its feet in cutting rates, it's safe to assume it will last a very long time.

However, I warn you again, stocks don't go up and down in a straight line, there will be many powerful counter-trend rallies but the dominant trend in a recession is down.

What about bonds? They typically do well in a recession as do rate sensitive sectors like utilities and other defensive sectors with dividends (staples) but the rally in bonds we just went through will also pause and there will be more backup in yields, especially if inflation pressures persist.

In fact, for the week, Utilities (XLU) were up 3.9% followed by Real Estate (XLRE) which was up 2.48% and Communications Services, Staples (XLP) and Healthcare (XLV) which all registered slight gains. Consumer Discretionary got hit the hardest this week as shares of Amazon got clobbered 9% today:

 But don't be fooled by the rally in defensive stocks, there's still plenty of speculation going on.

How do I know animal spirits are alive and well in this market? Just check out the rally in Cassava Sciences (SAVA) today, up 24% and more than 200% since mid-July when it tanked to $8.79:

And this despite the biotech index falling to late March levels:

Lastly, all this talk about the end of the carry trade and global deleveraging is blown way out of proportion.

No doubt, the yen has rallied recently but only after reaching a multi-year low of 161.94 in early June versus the US dollar:

To all those screaming the carry trade is over, chill out, the yen rallied for all sorts of reasons, the Fed and rate differentials being the most important one and while there is some deleveraging going on, the carry trade is far from over.

Alright, let me wrap it up there, we shall see what next week brings but don't be surprised if stocks bounce back led by small-caps and growth shares.

Below, Cedric Chehab, global head of country risk at BMI, says "one thing that people aren't remembering is that usually, between the period of July and October, there's a seasonal rise in volatility for equity markets."

And a comprehensive cross-platform coverage of the US market close on Bloomberg Television, Bloomberg Radio, and YouTube with Alix Steel, Scarlet Fu, Carol Massar and Tim Stenovec. 

Update: Given the huge selloff on Monday morning with the VIX spiking above 60, I added some more clips for you to watch but my thinking hasn't changed, people are reading way to much into the end of the yen carry trade. Listen to Jim Perry and Tom Lee below.

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