Jp Morgan sees light at the end of the carry trade tunnel: 75 per cent of trades closed

Carry trade among the most searched words on Google in recent days. Because it represents the grey swan that has hit the markets in this early part of August, triggering an increase in volatility comparable to the days of the Covid and subprime crisis of 2008. Analysts at Jp Morgan, however, are beginning to see light at the end of the carry trade tunnel. According to the bank's analysts, 75% of the trades would be closed. Thus, a quarter of the work would be missing before this thorny affair for global financial stability could be put behind us. The closure practically evaporated in a few days the gains accumulated by these traders over the past two years.

Taking a brief summary of what happened, on Monday 5 August the Tokyo Stock Exchange lost almost 13%, marking the worst session since the black Monday of 19 October 1987. The panic selling - which then also reverberated on the other global stock exchanges - was triggered by the forced closure of many carry trades opened over the past two years by professional traders on the Japanese yen. In practice, since the Bank of Japan did not decide to leave rates unchanged despite inflation rising while the Federal Reserve raised them to 5.5%, an abnormal rate differential between the two economic areas was created. As a result, the yen depreciated by 30% against the dollar to levels not seen since 1985.

With a weak yen and zero rates in Japan, many investors decided to implement carry trades by borrowing money in yen to invest in more profitable assets outside Japan. However, when the Bank of Japan decided to raise rates to 0.25% in early August - indicating that it would continue to do so at future meetings - the house of cards for the 'carry traders' began to shake. So they had to close their trades. How do you close such a carry trade? One has to sell the most profitable asset bought with the money borrowed in Japan. Assuming a carry trader bought US technology stocks (which is quite probable considering the extraordinary correlation over the past two years between Nasdaq performance and the dollar/yen exchange rate), he first had to sell the stock on Wall Street. The second step was then to convert the dollars into yen (because debt has to be repaid in yen) and this triggered a further strengthening of the yen, in turn prompting other traders to have to close (because of the yen's rise) other carry trades.

Thus the 'Japanese carry trade bubble' that has swelled over the past two years due to the excessive divergence between the BoJ's and the Federal Reserve's monetary policy has burst. No one can know for sure when this will end, but according to Jp Morgan we wouldn't be far off, since 75% of the carry trades opened in the last two years have been closed. That's 25% short, so if the estimates are true it cannot be ruled out that we will have more volatile sessions. But at least no risk of financial stability in global markets.