The carry trade has been a staple of financial markets for decades but it rarely made the front page until this summer, when its unwinding was blamed for the sharp sell-off in Japanese equities.
Contrarian multi-asset manager Ruffer expects the unwinding of the carry trade to continue, reversing the flow of global liquidity and making markets more fragile.
Ruffer Investment Company co-manager Duncan MacInnes said early August was “the really acute moment where this just popped up onto everyone's radar”.
When the Bank of Japan raised interest rates and an imminent US cut appeared more likely after weak jobs data, the yen started to strengthen. Hedge funds and other market participants who had been borrowing in yen to invest in higher yielding assets rushed to unwind their positions.
“When markets turn, it gets really nasty, very quickly. When markets get bad, people panic into the yen and the worse markets get, the more people have to close out their positions. So you get this self-reinforcing dynamic and that's what we're very worried about,” he said.
The problem going forward is that the carry trade is much larger than many market participants realise and will take a lot longer to unwind. Japanese interest rates have been close to zero since 1999 (when the Bank of Japan implemented a zero interest rate policy) so carry trades have been building up since then.
Western corporations such as Berkshire Hathaway have borrowed in yen to buy Japanese stocks. Japanese companies have borrowed in yen to invest overseas or buy foreign companies. Japanese individuals have gotten in on the act by borrowing money to buy stocks. And prior to the summer, hedge funds had been borrowing in yen to buy the Mexican peso.
Japan has the largest net foreign asset position in the world, MacInnes said. In other words, Japanese corporations and individuals own more foreign assets than any other country relative to the size of its gross domestic product (GDP).
“The size of this position is very large. It's taken years or decades to build up, so the idea that a couple of days of a wobble in August allowed everyone to sort themselves out, we think, is pretty unlikely and optimistic,” MacInnes said.
“We expect it will be more of a grind from this point as the fastest money has moved. This is something that will slowly but surely right itself over the course of probably multiple years from now, but it's a really big change in the flow of global capital.”
For many years, liquidity has been flowing in one direction: from Japan to the rest of the world.
“And now what if it reverses? That will take some adjustment. The key point is that the yen has been a marginal player in terms of people's thoughts about markets for a very long time, and it now is becoming front and centre," MacInnes said.
“We think the yen could act like a wrecking ball through risk assets. Yen strength forces carry trade unwinds, which equals the selling of risk assets and the forced buying of yen. This pushes the yen up and forces more unwinding, becoming potentially dangerously reflexive.”
Ruffer has been positioned for a strengthening yen for almost two years and currently has 15% of its portfolios in yen via short-dated Japanese government bonds.
The yen is about 30-40% undervalued so should boost portfolio returns as it appreciates, he said, as well as providing diversification against risk assets. “Having the yen in your portfolio is a really nice hedge because when the yen rises, your stocks sell off, so it balances your portfolio,” he explained.
MacInnes believes investors in Japanese equities should leave their currency exposure unhedged going forward – a reversal of the dynamic in recent years when investors would have maximised gains by hedging currency risk.