There’s the carry trade, and then there’s the carry trade.

Billions of dollars of these bets boiled off in a destabilizing flash over the summer. Trillions might remain, slightly different, less obvious and all but forgotten by a market eager to move on.

“Everybody's written about the carry trade, but they've not really written about the carry trade. It's broader, more complex and more convoluted than it's been sold,” said David Barrett, CEO of EBC Financial Group (U.K.), a London-based brokerage and asset manager.

The basic concept behind the strategy is simple and enticing. Traders borrow in currencies where rates are low and put that money to work in economies where rates are high, pocketing the difference. When risk-free U.S. government bills were paying more than 5%, yen was being loaned out at or near zero.

A good carry trade can quickly become bad news if the interest-rate gap narrows and the investors get squeezed. As the positions are unwound, the currency that was being borrowed strengthens, which increases the payback cost for those still in the trade.

This dynamic can make the rush for the door sudden and dramatic, and related knock-on effects are potentially devastating.

The surprise rate increase by the Bank of Japan in July might have triggered just that sort of cascading reversion, especially as it was met by a dovish U.S. Federal Reserve.

From early July to early September, the yen rallied from almost ¥162 to the dollar to just under ¥140, in part because carry traders were scrambling to buy yen to pay back loans they used for investment in higher-yielding opportunities.Knowing what’s left after the summer selloff is a challenge in part because no one is keeping track.

There’s no trading floor or regulator. No one publishes a league table. It’s a strategy, not a product, so it largely defies precise measurement.

“You don't have to report your carry trade to anyone. There's no lodging authority. In fact, it might be just simmering beneath, nobody knows,” said Lawrence Loh, professor of strategy and policy, National University of Singapore.The term carry trade covers a wide range of investment activity.

In addition to listed and traded financial products, it might include bank loans, official funding, corporate balance sheet investments and retail investment. Japanese residents with yen in their retirement accounts have been pouring money into overseas assets, and some might consider that part of the equation.

“The simple trade, most of those guys are out now,” Barrett notes."

Japanese bank foreign lending, at $1 trillion, was used in the Charles Schwab report as the proxy for the medium-term carry trade, while Japan's long-term net investment position, at more than $21 trillion, was used as the proxy for the long-term carry trade.

The U.S. brokerage said that in these last two categories exposure could be pared down over the longer term if the positions become less attractive.

“The BOJ's current hawkish bias offers the potential for a reversal of more than a decade of outward flow of capital to be felt by investors worldwide,” the authors of the report noted."

In 2023, Deutsche Bank analysts, including head of currency research George Saravelos, mentioned a $20 trillion carry trade. The bank has not released any similar analysis since, and Saravelos declined to be interviewed.

“With a need to diversify their balance sheet holdings, they inherently hold large overseas asset exposures. Even if they don’t explicitly call it a carry trade, it effectively functions as one,” Barrett said of the Japanese government.“The Government Pension Investment Fund holds about 50% of its assets in foreign stocks and securities, and Japan's private sector also has vast holdings of foreign assets,” he added. “The complexity of valuing these holdings, combined with various fluctuating inputs, means the valuation changes in these carry trades can be significant.”

“If rates rise, it could open Pandora’s Box, forcing losses to be realized due to P&L pressures,” Barrett said, noting that some traders have argued that this is why rates have been kept so low for so long.“This potential ‘car crash’ could play out over a longer timeframe than some might expect,” he added, describing a scenario in which possibly trillions of dollars are steadily withdrawn from global markets and converted back into yen. “Different participants have varying valuation thresholds and pain tolerances before they are forced to adjust their exposures.”

Barrett, who said that he has no current yen positions, notes that in some cases hedge funds borrow yen to use for more speculative investments, rather than just plain-vanilla government debt, in order to get an extra kick out of their punt.

Much of this money has found its way into technology stocks. The implications of an unwinding of these bets could be significant.

“A popular hedge-fund trade is to borrow yen, acquire dollars and stick it into an asset they think will go up more than the carry,” Barrett said. “They've got a cushion from the carry.”

“The yield differential acts as a buffer, allowing traders to leverage long positions in dollar tech stocks, which has recently been highly profitable,” Barrett added.

“That lurch down two or three weeks ago, when you saw the 24, 48 hour flap in tech stocks, I think that was some of those more complex trades getting unwound.

”Given the potential scope and scale of the carry trade, it might be a systemic issue of global concern, more than just a boutique investment trick that just endangers hedge funds late to the exits. Stocks, bonds and entire economies could be threatened by a great unwinding of sizable and fundamental investments built up over decades."

https://www.japantimes.co.jp/business/2024/10/02/markets/carry-trade-focus/