The problems of the $250 billion “carry trade” are far from over, warns the BIS – DL News

The partial unwinding of the so-called yen carry trade triggered a global market panic on August 5.

On that day, the Nikkei and the Topix – the two largest Japanese stock indices – closed down more than 12 percent, marking their worst day since the stock market crash of 1987. The S&P 500 and the Nasdaq, meanwhile, lost 4.2 and 6.3 percent, respectively.

Since then, markets have recovered and everything seems to be fine. But is it? The underlying problems behind the sell-off have not changed, an influential consortium of the world's central banks warned policymakers on Thursday.

Although a complete collapse of the markets was avoided this time, “the structural features of the system underlying such episodes continue to deserve attention,” says the report by the Bank for International Settlements.

Fulfillment of margin calls

Investors are taking advantage of low interest rates in Japan to borrow yen and use it to buy high-performing U.S. stocks and bonds – a strategy known as a “carry trade.”

While the extent of the yen carry trade is difficult to estimate, the BIS estimated that the value of yen-denominated loans to investors outside Japan was at least $250 billion as of August 5. However, this figure is likely to be significantly underestimated, as the BIS warned of data gaps.

At the end of July, the Bank of Japan announced that it would raise interest rates to combat inflation. This move came as a complete surprise to currency traders because it meant they had to sell their US holdings to pay the interest on the yen they had borrowed.

This is likely the reason why the turmoil rocked seemingly unrelated markets such as cryptocurrencies, the BIS report says. Both Bitcoin and Ethereum plummeted by as much as 20 percent in the following days.

“The impact of the unwinding was felt across many currencies and reflects the use of multiple funding sources and investments by carry traders,” the report said.

Markets are recovering

But in the end, the markets proved resilient, the report continued. “The speed of their recovery was remarkable,” it said.

There were no major exchange rate fluctuations, foreign exchange market volatility did not increase as much as in stocks, and trading in the US markets continued without disruption.

Nevertheless, the BIS urged caution, noting that the underlying problems behind the sell-off had not changed much.

Only some trades based on low volatility and cheap yen financing “appear to have been unwound,” the report said.

Some of these leveraged positions are even being rebuilt, the BIS said.

Even more worrying is that there are broader structural factors at play here. Markets allow large, risky positions to be built up in calm times, which must be quickly reduced when volatility increases.

“The dependence on leverage for many of these positions means that investors need to be more responsive to adverse shocks to avoid significant losses,” the BIS researchers wrote.

“If such behavior occurs in a nervous and illiquid market environment, volatility could increase further and set in motion a negative feedback loop.”

Joanna Wright writes about markets for DL News. Send her an email to [email protected].