There’s panic on Wall Street and around the world today, and it’s not bad economic news or a terrible earnings report that’s at fault. Instead, it’s a highly leveraged yen “carry trade” that has led to billions of dollars in selling and liquidations starting in the crypto market on Sunday night.
Very few assets are up today, but the notable moves are the S&P 500 (^GSPC -2.29%) falling 2.99% and the Nasdaq Composite (^IXIC -2.71%) losing 3.7% as of 10:00 a.m. ET. Growth stocks have taken a nosedive with many down double digits.
What is the yen carry trade?
Hedge funds and other large institutional traders have put on what’s known as the yen carry trade. It works like this:
- Borrow yen at a low interest rate.
- Convert yen to another currency, often U.S. dollars.
- Buy assets that yield an interest rate higher than the Yen rate in (1). Ex. U.S. treasuries.
If yields and exchange rates don’t change, this is a brilliant trade because it is a simple arbitrage that prints money month after month.
But something has changed. The interest rate on Yen debt is rising; the prior range was 0% to 0.1%, and the Bank of Japan announced a rate increase to 0.25% on Friday, bucking a decade-plus trend of essential zero rates.
Higher rates strengthened the yen against other currencies, making it more costly to convert U.S. dollars to yen. This caused massive losses in the carry trade trade.
Finally, rates in the U.S. are coming down, with the U.S. 10-year yield off 55 basis points in the last month.
Add all of this up, and the yen carry trade has become a money loser over the last month and blew up over the weekend.
The crypto canary
Investors knew something was wrong on Sunday night at about 8:00 p.m. ET when Bitcoin (BTC -8.68%) crashed 10% and Ethereum (ETH -15.54%) lost 20% of its value in a matter of minutes. The tokens have now been down 12% and 18%, respectively, in the last 24 hours.
Liquidations caused the rapid move in crypto and may have been set off by the yen carry trade imploding. In just the last 24 hours, there have been $1.24 billion in crypto, which may be a sign of what’s coming.
More liquidations may be coming
What’s unique about the trading over the past 24 hours is the entire move is related to leveraged trading positions, not fundamental economic or earnings changes. But the fact the yen carry trade is inherently a leveraged trade means there can be billions of dollars of positions (long and short) unwound in a short amount of time.
This could mean investors are forced to sell stocks, bonds, treasuries, or other assets just because of losses in the carry trade. And this involves the positions of entire funds, not just the carry trade itself.
This could lead to a broad sell-off over a long period as positions are unwound and that could take weeks or months. Or it could be a flash crash that’s over by this afternoon.
When leverage is involved there can be wild moves and that’s what we see with the unwinding of the carry trade. What comes next will be determined by whether the market finds more distressed assets or unsustainable leverage in the market.
If more big trades are unwound, this sell-off could continue.
Travis Hoium has positions in Ethereum. The Motley Fool has positions in and recommends Bitcoin and Ethereum. The Motley Fool has a disclosure policy.