Sep 29

The Carry Trade Unwinds: Negative Impacts on US Equities

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We’ve all heard about the ‘carry trade’ in the press.  Although, it did arise in discussions more often earlier in the year than it does now.

However, it may now be time to resurrect the discussions about what might be going on and the impact for US financial makets.

When an investor enters the carry trade, it typically involves selling Japanese bonds (in effect borrowing at the low JGB rate of about 1%) and investing in other securities (typically US Treasuries) that yield well in excess of the cost of borrowing.  Even with Friday’s drop in UST yields, the carry trade still creates ‘positive carry.’  Of course, as this gap in yields decreases, investors (mostly hedge funds), will look to reduce their exposure in the carry trade, since negative movements in prices between UST and JGB can more easily swamp the gap in carry trade yields.

I think that one obvious trade to reduce risk in those instances would be selling risky assets (for example, the S&P 500) and buying back the JGB.  Thus, if there is an unwinding of the carry trade, one would expect that movements in the S&P 500 might have some correlation with the Japanese Yen/US$ exchange rate.  In other words, an unwinding would bring drops in the SP500 along with strength in the Yen/$ exchange rate.

Back in late February, people were blaming China’s stock exchange price turmoil for its negative impact on the SP500.  Interestingly, before that sharp downward movement in US equities, there appeared to be virtually no correlation between the SP500 and the Yen/$ rate.  However, once that movement occurred, the correlation turned sharply positive.  In other words, the carry trade has indeed been unwinding.

Data Interval Date Correlation SPX Return SPX End. Price JPY end price
Daily Monthly 8/26/06 – 09/26/06 0.70% 3.35% 1336.34 117.11
Daily Monthly 9/26/06 – 10/26/06 3.00% 4.06% 1389.08 118.38
Daily Monthly 10/26/06 – 11/26/06 1.50% 1.06% 1400.95 115.9
Daily Monthly 11/26/06 – 12/26/06 0.10% 1.32% 1416.9 119.15
Daily Monthly 12/26/06 – 01/26/07 2.20% 0.48% 1422.18 121.54
Daily Monthly 01/26/07 – 2/26/07 13.10% 2.13% 1449.37 120.65
Daily Monthly 2/26/07 – 03/26/07 72.30% -0.69% 1437.5 118.13
Daily Monthly 3/26/07 – 04/26/07 18.10% 4.07% 1494.25 119.57
Daily Monthly 4/26/07 – 05/26/07 31.80% 1.62% 1515.73 121.79
Daily Monthly 5/25/07 – 06/26/07 30.00% -1.36% 1492.89 123.26
Daily Monthly 6/26/07 – 07/26/07 40.40% -0.58% 1482.66 118.68
Daily Monthly 7/26/07 – 08/27/07 36.60% -0.88% 1466.79 115.87
Daily Last month to date 8/27/07 – 09/7/07 88.90% -0.80% 1453.55 113.38
Daily Feb date of sell-off to date 2/26/07 – 09/07/07 46.50% 1.28% 1453.55 113.38
Daily 6 months prior to Feb sell off 8/26/06 – 02/26/07 0.40% 13.01% 1449.37 120.65

Please note from the chart above that there has been a 46% correlation between the SP500 and Yen/$ exchange rate since that day in February, versus virtually no correlation in the six months prior.

Importantly, the correlation has been north of 30% since the latter part of May, with the SP500 sinking and the Yen strengthening versus the $.  And for the most recent two weeks of SP500 turmoil, the correlation has been quite high at 89%.

The carry trade is unwinding and, with recent rate drops in the UST curve, appears to be getting even less attractive.  Hedge funds are strong players in the carry trade.  They are pulling in their horns and risk profiles, hoping to ride out this tough spell in the markets.

One can only hope that the herd instinct (and quantitative models) of these hedge funds does not produce a more virulent downward spiral in equities.  My concern is that this herd instinct may be further ignited by quarterly redemptions due hedge fund investors at the end of this month.