The explosive moment of the Japanese Yen Carry Trade

Today, the Nikkei 225 fell by 12.4%, dropping by 20% in the past 3 trading days, wiping out the year's gains in just three days. Meanwhile, Nvidia plunged 14% in after-hours trading, the South Korean stock market plummeted by 10%, the Nasdaq 100 dropped by 5%, Bitcoin plummeted by 15%, Apple also plummeted by 10% under the influence of Warren Buffett halving his holdings, and the Taiwan, Japanese, and South Korean stock markets all experienced their largest declines in history, causing chaos in global stock markets.

The impact on A/H shares was not significant during morning trading, but in the afternoon, Japanese stocks accelerated their decline, dragging down A/H shares by 1-2%. This is a global gold rush caused by unwinding of the Japanese Yen Carry trade, and the world is eagerly anticipating how much the U.S. stock market will fall when it opens tonight, reminiscent of the script of the U.S. stock market circuit breaker during the pandemic in 2020.

The global plunge caused by Japanese stocks is not only due to the end of the Carry trade. In the past few months, there have been significant changes both macroscopically and microscopically. Let's review what has happened.

Firstly, after the YCC policy ended in March, most market views believed that the Japanese Yen would appreciate, leading to a decline in Japanese stocks (damaging the profits of export companies). However, contrary to market expectations, the Japanese Yen accelerated its depreciation from 150 in March to the key level of 160 in July, a trend that was unexpected.

During this accelerated depreciation, Nvidia hit new highs, driving the continued surge of chip stocks in Japan. From March to June, the market's expectation of a rate cut by the U.S. dollar within the year gradually weakened, with more funds leaning towards a single rate cut within the year, or even no rate cut.

Therefore, even if the U.S. dollar only cuts interest rates once within the year, or even does not cut interest rates within the year, it can be seen that despite the removal of negative interest rates on the Japanese Yen in March, the Japanese Yen exchange rate continued to weaken rather than appreciate. The most important marginal change here is when the U.S. dollar cuts interest rates. The earlier the U.S. dollar cuts interest rates, and the larger the rate cut, the greater the impact caused by the Carry trade, mainly depending on the interest rate differential between the two sides.

However, on July 31st, the Bank of Japan raised interest rates by 15 basis points to 0.25%, and on August 2nd, U.S. non-farm data continued to weaken, with CPI weakening for two consecutive months. Market expectations shifted again from no rate cut within the year to a rate cut of 1 time, to a 25 basis point rate cut in September, and even rumors of recession trading emerged. The interest rate differential between Japan and the U.S. rapidly narrowed, with multiple macro changes in a short period of time, leading to the beginning of the trampling caused by the Carry trade Since Japan introduced negative interest rates in 2016, it has been unclear how much capital in the US stock market has been borrowed from Japan in the past 8 years. At least the scale of funds borrowing yen to invest in US stocks is not small. When the yen aggressively raises interest rates and shrinks its balance sheet, it causes the funds borrowing yen to invest in US stocks to start "unwinding" by selling stocks and repaying yen.

Here, we quote Fu Peng's views on the technology stocks "Bitcoin Explosion" and "Circle Shrinking".

The funds borrowing yen to invest in US stocks are mostly buying NVIDIA. Short yen+Long Mag 7+Short VIX high volatility has been the most crowded trading strategy in the past year. As of July, the scale of these long positions has reached a new high, so when the Carry trade arbitrage reverses, the most crowded strategy starts to unwind. The funds borrowing yen start selling the technology "Seven Sisters" and exchange stocks back to yen to repay.

So, why does the unwinding in the US stock market affect the Japanese stock market?

In the Carry funds borrowed and lent in the Japanese stock market, the main flow is towards two types of assets in Japan. One is the five major Japanese trading companies that Buffett borrowed yen to buy, where cash cows can receive high interest rates to hedge against exchange rate risks. The other type of asset is Japanese chip stocks, which mainly follow NVIDIA's rise. In the past year, they have risen to 1-2 times their levels, with PEs also speculated to be around 30-40 times.

It is worth noting that Japanese chip stocks supply NVIDIA, but funds may only be willing to give a PE of up to 30 times, and they cannot give a higher PE. So, at this time, when the "shadow stocks" of NVIDIA cannot rise (volatility decreases), and the market sees that NVIDIA can still rise, a suction effect occurs. Funds may sell the "shadow stocks" of Japanese stocks and buy NVIDIA, leading to a high concentration in the market, and funds start "shrinking circle trades".

For example, Tokyo Electronics has fallen by 44% since April, even if we exclude the recent 30% drop in the past 3 days, Tokyo Electronics has also fallen by 21% in the past 3 months, underperforming NVIDIA with a 30% increase, underperforming TSMC with a 20% increase, and underperforming the S&P 500 with a 6% increase. This is the phenomenon of shrinking circle trades.

As shown in the figure below, first, the Nikkei 225/S&P 500, which are the furthest outside the circle, cannot keep up with the rise of Tokyo Electronics and the S&P 100, then Tokyo Electronics/S&P 100 cannot keep up with Microsoft/Apple, and finally Microsoft/Apple cannot keep up with NVIDIA. This is exactly the hottest trading trend in the past year, where the technology "Seven Sisters" lead the S&P 500 and Nasdaq to rise, while the rest of the hundreds of stocks have not increased much, or even fallen, showing that the indices are performing well, but on average, the increase in each company is a different story

When carrying out the Carry trade by selling NVIDIA to repay the yen, it will also lead to a decline in Japanese stocks, as they are essentially shadow stocks of NVIDIA's rise. When the core NVIDIA within the circle starts to decline, the decline of shadow stocks will be more pronounced.

Such trading scenes in the market are not uncommon. It's just that when the concentration of funds reaches its peak, the fundamentals of NVIDIA/tech 7 sisters cannot afford to miss a beat. If, like last Friday, NVIDIA's B100 server shipment is delayed, it could potentially plummet by 6% in a single day.

To be honest, NVIDIA didn't fall much at the close last Friday, indicating that most funds do not believe that the delayed shipment time will affect performance. It's just that short-term/leveraged funds inside may feel uncomfortable because not only is the stock price not rising, but the volatility when it falls is also significant. However, if there is a bit of negative news leading to a big drop, most leveraged funds will start to panic and begin to sell off.

Until today, news of Warren Buffett reducing his Apple holdings by 50% over the weekend has also come out. This not only negatively impacted Apple's stock price, but today the yen accelerated its strength, attracting funds borrowing yen to buy US stocks to sell stocks and repay the yen.

According to the Japan Exchange, as of July 26, the mini Nikkei 225 futures positions, which were just launched last year, hit a historical high. With huge fluctuations of 10-20% in US and Japanese stocks, undoubtedly many leveraged funds have been hit hard. How should this situation end now?

Conclusion

After the close of the Japanese stock market, the Federal Reserve announced that they will hold an emergency meeting with the Bank of Japan today.

Market rumors suggest that the next plot will be similar to the circuit breaker in 2020. Powell will urgently cut interest rates to rescue the US stock market, even suggesting a 100-125bp rate cut for the US dollar within the year. Will it happen in September instead? Or will the Bank of Japan step in to buy ETFs to support the stock market? However, it is worth mentioning that signs of a US economic recession are not clear, so these possibilities are unlikely.

During the sharp decline in Japanese stocks, interest rate differential expectations made a 180-degree turn. This is truly a Black Monday and a week that will go down in history (ending the yen Carry trade + turmoil in the Middle East + Buffett's significant reduction in Apple holdings)