Carry Trade

What the Heck is a “Carry Trade” and Why Does it Matter?

On Monday August 5th, we got brutal news out of Japan. The Nikkei stock index fell 12.4%. That was the largest decline since the 1987 stock market crash. That fall, called “Black Monday,” kicked off a major recession. 

When U.S. markets opened that morning, the Dow Jones Industrial Average fell 1,000 points and the Nasdaq lost 6%. 

This happened, in part, because Japan had the world’s lowest interest rates for decades. Imagine that you could borrow money for almost nothing and invest it in U.S. stocks. For example, let’s say you borrowed $1 million in and put it into the S&P 500 a year ago. You made about $250,000 in profit, in one year. 

That’s the index. Now think about individual stocks. Over the past year, Nvidia shares peaked at 200% gains. For every million dollars you borrowed, you made $2 million. That dwarfs the S&P 500, as you can see here:

That’s a trade everyone wanted to do…so they did. And have done for a long time now. It’s the reason those stocks soared so high. And it’s why those same stocks are going to come crashing down.

On Wednesday July 31, 2024, the Bank of Japan surprised everyone by raising interest rates from zero to 0.25%. Just a quarter of a percentage point. As you can see, the market didn’t take that news well:

Shares began to fall immediately. And that kicked off a cascade of unwinding the carry trade. 

Add to that disappointing earnings from the big tech companies. The world wasn’t buying as much as analysts expected. 

Expert investors like Warren Buffett began to sell over the last couple of months. Buffett, famously not a tech investor, took a huge $1 billion stake in Apple in 2016. He made 800% on the trade. But he sold half his position in the last 3 months, well before the peak. 

His timing was excellent. The so-called “Magnificent Seven” tech stocks got clobbered. Meta (Facebook) fell 6% through August 5th. Amazon (-17%), Microsoft (-12%) Nvidia (-19%) were also among the biggest losers.

The reason was the carry trade.

Remember, we borrowed that money, so we have to pay it back. And we have to pay a modest fee as well. In order to do that, we need cash…so we have to sell stocks. 

And that carry trade was huge. According to Japanese officials, it was between $85 billion and $170 billion. Goldman Sachs estimated that it was 5% of Japanese gross domestic product or just under $250 billion.

However, Jesper Koll, an economist at Merrill Lynch, believes it’s much larger. He told the Financial Times (FT): 

“This Y6tn ($51bn) surge in non-Japanese funding is a new development that, in our view, points to the true carry of yen-funded leveraged position build-up in the recent past. 

…the absolute size [of this carry trade is] maybe around $1tn, with about a third of the positions built up in the past 12 months”

Michael Woolfork of the Bank of New York, also featured in the FT, said:

“I suspect that what little carry trade unwinding was seen in the past two weeks was only the tip of the iceberg compared to the remaining trades that are still on the books.”

That means we need to restrain ourselves from buying the dip here. Many stocks, certainly big tech, are still expensive. And they are still the most likely companies to be hit by further unwinding of the carry trade. 

Be cautious now. Sellers right now are probably carry traders. We don’t want to be their escape plan.

If Woolfork is correct, this could be the first cracks in the dam. We don’t want to commit our capital in time for the actual flood. We want to hold our cash until this carry trade really unwinds. Then we can buy the best stocks for cheap.

For the Good,

The Mangrove Investor Team

Numbers You Need to Know

1999

If defined broadly as using a low-yielding yen to buy higher-yielding foreign assets, then the carry trade origins can be traced back to 1999 when Japan struck policy rates down to zero after its asset price bubble burst. (Reuters)

0%

The Bank of Japan has kept interest rates at or near zero for years, trying to encourage more spending and spur economic growth. (Associated Press)

110 Billion

Hedge funds started unwinding risk roughly two weeks ago, when stocks started to fall. Morgan Stanley estimated on June 25 that macro hedge funds could sell $110 billion in the coming weeks if markets further deteriorated. (Rueters)

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