What Are Carry Trades and How Did They Contribute to This Week’s Global Market Mayhem?

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Carry trades involve borrowing at low cost in one currency to achieve higher returns from investments in another currency. Investors borrowed Japanese yen, expecting the currency to remain cheap against the US dollar and for Japanese interest rates to remain low. The borrowed funds were invested in US stocks and Treasury bonds in anticipation of a higher return.

Japan raised its interest rates and there was a cascading effect that roiled markets globally. Losses on Monday were substantially recovered on Tuesday.

ZeroHedge argues that the recovery rebound is tepid and that the meltdown is not over.

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The mayhem that swept across world markets this week was partly caused by a market strategy known as the “carry trade.”

Japan’s benchmark Nikkei 225 plunged 12.4% on Monday and markets in Europe and North America suffered outsized losses as traders sold stocks to help cover rising risks from investments made using cheaply financed funds borrowed mostly in Japanese yen.

Markets recovered much of their losses on Tuesday. But the damage lingers.

They were jolted by a combination of factors, including dread of a possible recession in the United States, the world’s largest economy, and worries that technology shares have shot way too high this year.

But the scale of the declines was exaggerated by the rush to sell U.S. dollars due to carry trade deals that had helped drive markets to record levels.

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What are carry trades?

Carry trades involve borrowing at low cost in one currency to achieve higher returns from investments in another currency. One of the most recent examples has been to borrow Japanese yen, expecting the currency to remain cheap against the U.S. dollar and for Japanese interest rates to remain low. The borrowed funds would then be invested in U.S. stocks and Treasury bonds in anticipation of a higher return.

Why have traders been unwinding their carry trades?

The key factor behind a carry trade is a difference in interest rates. The Bank of Japan has kept interest rates at or near zero for years, trying to encourage more spending and spur economic growth. Last week, it raised its main interest rate from nearly zero. Higher interest rates tend to boost the value of a nation’s currency, and the Japanese yen surged against the U.S. dollar. Traders scrambled to sell higher risk, dollar-denominated assets to cover suddenly higher borrowing costs, plus losses from foreign exchange rate changes and losses in asset values as share prices plunged. Also, hedge funds that conduct carry trades use computer models to help maximize their returns versus their risks. They needed to sell shares to maintain acceptable risk profiles.

Why do carry trades have an outsized impact on markets?

Carry trades tend to make the most sense when foreign exchange rates are relatively stable and investors can tap into higher yielding market opportunities, like the recent runups of stock prices in places like the United States. The recent market upheavals obliged traders to cover their debts by buying yen and other carry trade currencies and selling relatively more of the higher risk assets they bought under more favorable conditions. Also, carry trades are very lucrative when stocks or other investments are rising, but losses can snowball when thousands of traders are pressured to sell stocks or other assets all at once. “A massive global carry trade unwind was the spark that lit the fuse for this market Armageddon,” Stephen Innes of SPI Asset Management said. “One defining characteristic of these self-perpetuating market melts is the vicious cycle where a sell-off increases realized volatility.”

Read full article here…

Link for ZeroHedge article

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Jimbo
Jimbo
1 month ago

One fiat currency leveraging itself against another in proxy creates no wealth, only transfers it to system gamers. How much more cents does it make to go with transactional gold (&silver) as constitutionally imprimatured state created legal tender, physically owned in repository, transacting by debit-card, and convertible back-and-forth to US fiat-paper money at discretion of owner? All that without incurring IRS capital gains liability each being valid US currency. Gold not being a commodity any more in this format. Check out increasing numbers of states following Texas’ lead to secure our money supply from endless Fed-cartel manipulation through activating reserved… Read more »

MJRaichyk, PhD
MJRaichyk, PhD
1 month ago
Reply to  Jimbo

Are the states following Texas with its Depository and ? credit card, being followed on the Tenth Amendment Center webpages?? or where… so I can check my own state… ttyl

MJRaichyk, PhD
MJRaichyk, PhD
1 month ago

Is there a resource out there that lists each bank or investment entity along with the size of the CARRY TRADE activity..?
None of my selected stocks showed anything like this idiotic hysteria, but then again I choose my stocks as if I am buying into a user co-operative.

Why should we weep over gamblers’ losing or even almost losing?
Choose your own stocks to make your life dull but rewarding and not dependent on DEBT-fools with greed schemes.

Andrea Plamondon
Andrea Plamondon
1 month ago

Trying to find ones way in the market today or in the world is daunting to say the least… just human nature and timeless greed in action…