The carry trade as risk driver

Posted by Cam Hui -

Preface: Explaining our market timing models

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

 

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

 

 

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
  • Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)
  • Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

 

 

Watch the Yen

Even as equity markets turn risk-off, the real driver of risk appetite may be coming from cross-asset considerations and determined by hedge fund risk management policy. The combination of a hawkish shift in BOJ monetary policy and an easier tone to Fed policy has forced an unwind of the Yen carry trade. For the uninitiated, carry trades are where a investor borrows in a low yielding currency such as the Japanese Yen and invests the proceeds in a high yielding one. Since the yields spreads are relatively small, hedge funds take on carry trades with leverage, and lots of it.

 

A carry trade unwind forces carry traders to flatten their positions. As the positions are taken on with leverage, a rush for the exits by leveraged traders is exporting cross-asset volatility to the rest of the hedge fund’s book, which forces a de-risking and deleverage of other asset classes. That’s how disorderly panic sell-offs happen.

 

Is the panic over? From a technical perspective, both the 10-year Treasury-JGB yield spread and the Japanese Yen are testing the support zones, which may serve to stabilize asset prices as the USDJPY consolidates in the support zone.

 

 

 

What’s the downside risk?

Turning to the U.S. equity market, here are bull and bear cases as the S&P 500 violated its 50 dma.
 

The bulls will argue that downside risk is limited at these levels, barring some unexpected exogenous event. The index tested its 50% retracement level at 5300. The stochastic has recycled from oversold to neutral, which is a tactical buy signal, and the 5-day RSI is exhibiting a positive divergence.
 

The bears argue that the index exhibited an island reversal pattern with a measured target of 5100.
 

 

 

Nearing a bottom

Notwithstanding these the carry trade crosscurrents, conventional technical analysis that strictly focuses on the U.S. equity market leads us to believe that a bottom is near and near-term downside is limited.

 

Two of the five components of my Bottom Spotting Models have flashed buy signals again. The VIX Index has spiked above its upper Bollinger Gand, indicating an oversold condition, and the term structure of the VIX is inverted, indicating fear.
 

 

Goldman’s U.S. Panic Index, which is composed of a rolling percentile of four equity volatility indicators, has spiked to levels consistent with past short-term bottoms.

 


 

 

As we proceed through Q2 earnings season, the good news is forward 12-month EPS estimates are rising, which is an indication of fundamental momentum. The bad news is the sales beat rates are well below historical norms.

 

 

 

 

A question of leadership

If the market is bottoming, the bigger question is, what leads the market upward in its anticipated rebound? I am inclined to be cautious about the old AI-driven leadership. In particular, the semiconductor stocks, which have been the poster child of the AI investment theme, and have been unable to overcome overhead resistance after violating a rising trend line in June. The relative performance chart (bottom panel) especially highlights the weakness of this group as it tests its 2024 relative lows.
 

 

I would look for leadership in small cap and value stocks. Even as the S&P 500 violated its 50 dma, small caps holding above their 50 dmas.
 

 

The superior relative performance of value over growth is evident across all market cap bands and internationally.
 

 

There is a distinct difference in breadth between NYSE issues, which tend to tilt towards value, and NASDAQ, which are growth oriented.
 

 

These trend changes have been abrupt, but they look sustainable.
 

From a fundamental perspective, Magnificent Seven earnings growth is expected to decelerate, while earnings growth for the rest of the S&P 500 is expected to rise. This is supportive of my rotation from growth to value investment theme.
 

 

In conclusion, risk appetite is undergoing a cross-asset carry trade-driven panic and a bottom is near. The equity market is sufficiently oversold and poised for a relief rally. Barring some unexpected exogenous event, downside risk is limited at these levels. Expect a short-term relief equity rally into August, led by small caps and value stocks.

 

My inner trader remains long small caps. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long TNA
 

5 thoughts on “The carry trade as risk driver”

  1. Three points to note:
    1. Markets have a way to go to extremes. Over valuation leads to excesses that need to be corrected.
    2. In my opinion the political fundamentals have shifted from a pro-capitalism to a socialist trend. You will see more articles that bash big corporations not paying adequate taxes etc. This has major long term implications.
    2. Having paper stops in the market while trading is a form of insurance. Similar to earthquake, homeowners or car insurance. In most cases you don’t need it but boy it does help to save those trades that can wipe out a year of gains/good trades.

  2. They will use any excuse. Good news is bad news or good news is good news.
    OK, the spread between USD rates and JPY rates has changed a bit, but back in 2021 it was a lot less, and if the Fed lowers rates in Sept or Dec or whatever, it will affect the spread more than what the BOJ did.
    Unwinding an over leveraged trade does matter though, just like LTCM in 98 mattered.
    It’s the debt that can kill you.
    As far as IMT’s comment about socialist trends, I think it’s inevitable. Human nature is that many won’t accept personal responsibility, but want to blame others. Well the middle class is hurting and many are living paycheck to paycheck while seeing billionaires being made , it’s no surprise that things are drifting in that direction. I hope it doesn’t go too far, but the politicians will do “whatever it takes” to get elected and stay in power.

  3. My Tactical Factor Rotation Research flagged a Low Volatility Tremor on Friday for the first time since the beginning of 2022 and that year’s bear market. Low Vol Factor is now leading the other three , Value, Small Cap and Quality. This happens when professional money managers shift to low volatility stocks when the see a bear market ahead. This is a key caution flag that I have studied back fifty years. It is sometimes early. I hope for a quick reversal but if not, it is a bad omen. BTW Europe has been in a Low Vol Tremor for the last few months already.

    Last week, the Fed Fund Futures plunged in truly historic fashion, especially the December 2025 contract. This futures contract is used by big institutions not speculators. There is a narrative happening that the Fed has waited too long to cut. The magnitude of last week’s rate drop shows in my opinion that the experts are expecting a hard landing starting now. This type of interest rate drop is NOT a friendly thing.

    CCC junk spreads soared last week too. If the spreads go above the high of two months ago, head for the lifeboats. If they fall below last week’s low, the outlook clears to risk-on.

    The only sector (countries, industries) that is now positive with internal factor momentum is Utilities. Internal high and low momentum in my opinion should stay positive over 90 days in a bull market. It is not as of now.

    Commodities are plunging as China, Japan and Europe are slipping into recessions. Global stocks are weaker than U.S. As we watch U.S. statistics day by day, the world is weakening outside our media watch.

    On my Tactical Factor U.S. Weather Chart, I have shifted from Autumn to Winter as in a bear market. I do this due to my Factor and Momentum research as well as the macroeconomic outlook. If the above things rebound I will be risk-on again. It will be perfect if I get a TWIST to signal a firm bottom.

    1. Thanks for your insights. This is in line with Cam’s Trend model turning Neutral. I will be interested to hear when your models turn risk-on again.

      1. Obviously I had no crystal ball, but I am glad to see the Trend Model turn neutral and take profits before the turmoil started.

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