Over the weekend, I wrote that risk appetite is at the mercy of the carry trade (see The carry trade as risk driver). I did not expect that the Yen would continue to skid badly and the Nikkei would crater by -12.4%, which is its worse one-day decline since the Crash of 1987. While correlation isn’t causation, and the price scales are different, the Nikkei has shown a close correlation to the NASDAQ 100 in the last year.
The carnage in Japan was so bad that it prompted some people in my social media feed to distastefully quip about seppeku, or Japanese ritual suicide. While it’s impossible to know in real-time when the panic ends, here are some clues on how to navigate the Seppeku Panic of 2024.
A leveraged position unwind
The VIX Index spike above 65 overnight before retreating, which is a level last seen in 2008 at the height of the GFC, and 2020 during the COVID Crisis. Both episodes had legitimate reasons for fear to soar. 2008 saw the global financial system close to the brink, and 2020 saw the global economy come to a sudden stop. What happened this time? The near-term catalyst is a position unwind of a leveraged carry trade that poses minimal systemic risk. The VIX closed the day at 38.56. As a frame of reference, a VIX of 40 implies an average daily swing of about 2.5%, which isn’t sustainable.
As a reminder, a carry trade is when a trader shorts a low-yielding currency and buys a high-yielding one. Nautilus Research identified one popular pair, long Australian Dollar/short Japanese Yen, and found that dislocations in AUDJPY tended to resolve in risk-on rebounds soon afterwards.
Nevertheless, the panic has overwhelmingly shifted the market consensus to a 50 basis point cut in the Fed Funds rate in September, with some observers calling for an intra-meeting rate cut. This is what panic looks like. An emergency rate cut would exacerbate the sell-off, as it would narrow the USD-JPY yield spread and push JPY even higher.
Spotting the panic crescendo
The only question is timing. How do we identify the crescendo of the panic?
One indicator to monitor is the shape of the VIX curve. The 3-month/1-month VIX has inverted, which is a sign of severe panic. The 1-month/9-day VIX has already been inverted for over a week. This is an indication of extreme fear.
This started as pullback due to US economic weak stats and a Fed that was likely behind the curve. That would have been your normal dip.
The further severe drop, in my opinion, is the carry trade technical earthquake. This reminds me of the market disruption of the overleveraged trade of Long Term Capital going bankrupt on a no-lose algorithm trade that overwhelmed market trading systems. I also looks like the Crash of 1987 when the stock and commodity exchanges couldn’t handle the surge in algo trading again.
The 1987 Crash was fixed quickly. The Long Term Capital took a Fed bailout as in longer.
This carry trade was a license to print free money for several years. Whenever we have that huge gains are made by many actors and a lot of them start leveraging up, some to the moon (like Long Term Capital). If you leverage twenty to one on margin and the trade goes offside by 15%, your stake is lost plus two times more. This becomes an issue as to who lent the money. Which bank or???
This carry trade wipeout should be over quickly unless the margin losses are extremely large like Long Term Capital’s. The Fed should not react to this margin call, It impacts carry traders not the US economy. If the do an intermediate drop in Fed Funds as Jeremy Siegel said to do, that would scream that the Fed bails out the stock market players. That is likely true but they should be subtle about it.
Thanks, Ken.
Carry trade unwind should bring cash back to Japan which then needs to find a home. Why the overnight sell off in Japanese equities?
It’s hard for outsiders to understand how ruthless margin sellouts are made in the commodity trading world. If a client’s margin account is even approaching a margin call especially if it might go underwater, they must come up with the cash needed immediately as in before the closing bell so the commodity trading firm can sell out the position if the cash doesn’t come or it is not enough.
Going underwater means that if the commodity position is sold out, the account will be left with a debit, as in client must come up with cash to bring it to zero. The firm loses if the client doesn’t pay up. Huge sudden market swings can do this overnight. I don’t deal in commodities but I had a client that traded gold. It went down the limit overnight so they couldn’t open trading. He said if they could, he would have lost his house. Luckily, it went UP the limit for a few days and when it finally opened he had made a lot of money.
During market turmoil, the firm’s back office margin department will put out rulings to their brokers about maintaining a cushion of margin and selling out immediately before the account goes underwater. The firm’s capital is on the line if clients lose beyond the money in their accounts. The credit department might even charge the commodity broker with any of their client’s unrecovered losses.
These crashes can go deep when indiscriminate margin selling hits the trading floor. Now you can see why.
When LTCM went bust the correction lasted a month. The SPY went down to the high range of the prior wave which was approx 15%, it went to the bottom of the ichimoku cloud on a weekly chart. A 15% drop would bring the S&P down to 4800, also at the bottom of the weekly Ichimoku cloud. . A month later it was back to making a new high. Something to keep an eye on. Just in case.
Thanks yodoc.