Investors have pulled money from a Japan-focused stock ETF as the yen carry trade collapses.
The WisdomTree Japan Hedge Equity Fund, ticker DXJ, saw outflows of more than $400 million last week, the most since 2018, data compiled by Bloomberg show. Meanwhile, short bets on the ETF’s float rose to the highest level since May, according to IHS Markit Ltd.
The fund, which invests in Japanese stocks while hedging against a weaker yen, has been rising over the past year thanks to low interest rates in Japan. But in recent days, all that has been turned upside down as the Bank of Japan shocked markets with an unexpected rate hike, causing the yen to appreciate against most major currencies and Japanese stocks to plummet. This is a painful reality for investors who borrow yen to buy high-yielding assets (carry trades).
“Japanese stocks have fallen sharply, which is creating selling pressure,” said Todd Sohn, ETF strategist at Strategas. “Also, if the yen continues to strengthen, DXJ becomes less attractive because the need for hedging is not as great.”
The Bank of Japan raised its benchmark interest rate in late July and unveiled plans to cut its bond purchases by half, strengthening the yen. Only about a third of BOJ watchers included a rate hike at that meeting as their base case scenario. But it showed the central bank’s determination to move forward with normalizing policy after years of ultra-easy policy.
The amount of money involved in the carry trade is disputed — estimates range from tens of billions to trillions of dollars. Amid these turmoil, DXJ has fallen 10% since the end of July. The fund's withdrawals last week gave it its worst month of outflows since December 2018, though it remains positive overall for the year.
“The impact is simply based on the fact that a stronger yen is bad for Japanese equities — it impacts earnings and potential market share,” said Mark McCormick, global head of FX and emerging markets strategy at TD Securities in Toronto.
Furthermore, positioning and flows may have exaggerated the change as Japanese stocks have been outperforming for some time.
So far, last Monday's global market crash looks more like a brief shock, a momentary panic triggered by a policy change by the Bank of Japan and fears of a U.S. recession. But the way it unfolded so quickly, and unravelled so quickly, exposed how vulnerable markets are to carry trade strategies.
"The yen carry trade remains at the center of everything in the market right now," said David Lutz, director of ETFs at JonesTrading in New York.
While markets have stabilized, the episode raised alarm about how much leverage has built up around Japan as the Bank of Japan continues to pump money into markets even as inflation surges after the pandemic. That has left anxious traders trying to gauge whether much of the liquidation is over or whether it will continue to spread through markets in the coming weeks.
Giving an answer is tricky because there are no official estimates of how much money is tied up in carry trades. Assuming all of Japan’s overseas borrowing since the end of 2022 was used to finance it and domestic investors used leverage to make overseas purchases, the strategy would put at about $1.1 trillion, according to GlobalData TS Lombard.
After last week’s dramatic unwinding, strategists at JPMorgan Chase & Co. believe three-quarters of global currency carry trades are now unwound, while strategists at Citigroup Inc. say current positioning levels have taken the market out of the “danger zone.”
But others, like BNY, think the unwinding may have further room to run, potentially pushing the dollar-yen exchange rate down to around 100, a drop of more than 30% from where it ended last week and marking a significant strengthening of the yen. “Further carry trade unwinding seems possible, but the most important and damaging part of this bust is now over,” Steven Barrow, head of G10 strategy at Standard Bank in London, wrote in a letter to clients last week.
“The fact is that the yen remains deeply undervalued, and those carry trades that remain are looking increasingly shaky as the Fed begins to ease policy,” Bloomberg strategists said. “But Monday’s episode was all about markets and will not create an adverse feedback loop for the real economy.”
As markets stabilize, there are signs that hedge funds are reducing bets that the yen will continue to appreciate. The recent changes may have temporarily suppressed carry trades, and traders expect more volatility in foreign exchange markets this year.
The carry-risk ratio on yen-funding trades against eight emerging-market currencies fell to its lowest level in about a year last week, data compiled by Bloomberg showed, suggesting the strategy’s returns have deteriorated.
“No trade lasts forever — the facts have changed,” said Jack McIntyre, senior portfolio manager at Brandywine Global Investment Management. “The Bank of Japan tightened policy and that caused something to collapse: this time it was the carry trade that collapsed.”
The article is forwarded from: Jinshi Data