Over the past two months, the foreign exchange Carry Trade has seen its second-worst drawdown since the inception of the euro. In the last week however, most of the high yielding currency pairs have stabilized leading many traders to wonder whether this may be the true bottom. The recent movements provide a good opportunity to review previous carry trade liquidations to see just how far we have come. Although certain pairs may appear to be good values, a historical examination of previous carry trade liquidations suggests otherwise. In fact, a tremendous Japanese Yen appreciation in the early 1990?s led to an almost unbelievable 30% unwind in the span of two years.
Though it remains highly unlikely that the carry trade will reach depths last seen in 1993, it serves to note that the recent drawdown remains smaller than the sell-off following the Russian debt default and LTCM crisis in 1998. This is important is because some people including US Treasury Secretary Paulson have argued that the latest turmoil in the credit markets could last longer than the turmoil caused by the Asian Crisis, Russian debt default and LTCM. In that case, carry trades could continue to suffer. In fact, a look at the chart below shows that the simple buy-and-hold strategy in 1998 fell 13.7 percent off of its peaks in a matter of months. By comparison, the recent July to August Yen rally has left the carry trade 10.3 percent off of its peaks. Though this is a mere 0.5 percentage points off of a similar trough in 2006, unease across financial markets hint at the fact that the worst may be yet to come.
Has anything changed since 1998?
The recent carry trade unwind began when a flight to quality across financial asset classes led the Japanese Yen significantly higher in a short period of time?a result remarkably similar to what we saw approximately ten years ago. Present-day troubles can be attributed to investor nervousness over the future of global credit markets and an overall re-pricing of risk. In August of 1998, Russia defaulted on international debt and sent global credit markets into a similar frenzy. The Japanese Yen subsequently rallied an incredible 20 percent against the Dollar in a mere two months following the event?unsurprisingly fueled by risk aversion across global trading desks.
Overall market sentiment and measurements of risk appetite have reached levels last seen since the Russian debt default and Long Term Capital Management collapse. Indeed, options traders expect the most Japanese Yen volatility since 1998. Much like we saw in the previous credit market crunch, volatility had remained depressed for an extended period of time. Yet this proved to be the calm before the storm?, as options markets swiftly corrected and drove prices significantly higher in the trading that followed.
Will the Yen Relive 1998?
The Japanese Yen has recently appreciated just over 10 percent off of its lows against the dollar, but this pales in comparison to the 20 percent surge we saw in 1998. Though this is in and of itself not an indication that it will behave similarly through the medium term, it does put the recent carry trade unwind into historical perspective… Yet traders seem increasingly certain on the future of the Japanese Yen ? both currency Forward rates and options signal the expectation for further USDJPY losses.
In fact, the one year forward on the USDJPY is currently being bid at 110.77?a full 454 points below current market levels. Such a bias in these over the counter transactions signals the fact that many major corporations are willing to guarantee an arguably expensive price for Japanese Yen. Just as significant are the Risk Reversals on currency options, which show the market?s incredible willingness to purchase calls on the JPY through the medium term. Measured as the difference in prices paid for highly speculative option prices, traders are significantly skewed towards purchasing JPY calls or USDJPY puts and the levels are the most extreme since 1998.
How Bad Can the Carry Trade Really Get?
Many have argued that the carry trade has little room left to fall after double-digit losses, but such arguments may prove short-sighted from a historically perspective. Given that financial markets have recently shown their propensity to make multi-decade record moves through a short period of time, it remains relevant to look back at similar moves in the past 25 years. The chart below shows just how bad the carry trade performed through the 1992-1993, when it fell a whopping 29.6 percent in a steady sell-off.
Clearly, a recurrence of such violent carry trade tumbles is highly unlikely. Yet such an image serves as a clear warning against trying to pick a bottom without first seeing a clear shift in market sentiment. A revisit to 1998 lows seems the more likely scenario, as recent market conditions are noticeably similar to those seen following the Russian debt default and LTCM collapse.
Written by David Rodriguez, Currency Analyst for DailyFX.com