Is the Carry Trade Liquidation Over?

Volatility made a grandiose entrance last week as the Shanghai Composite Index rocketed 8.8 percent lower in a single session, unleashing a wild unwind of carry trades that resulted in the biggest weekly gain in the Japanese Yen against the US dollar in 14 months while cross pairs like NZDJPY plummeted more than 9 percent. However over the past 24 hours, the rally in the Japanese Yen has eased back as global equities stabilized, leaving many traders wondering: Is the carry trade liquidation over? Has USDJPY bottomed out?

To attempt to answer these questions, involves looking back at the market’s most memorable period of carry trading unwinding. Between August and October of 1998 the Japanese Yen rose 20 percent against the US dollar. At the time, the global financial markets were in a precarious position amidst a perilous sequence of events. First, in August 1998, Russia defaulted on international debt – the event best known for bringing Long Term Capital Management (LTCM) to its knees. The news sparked a sell off in the equity markets as major players dumped their assets to cover margin calls and rapidly unwound yen carry trade shorts, propelling the yen 9 percent higher in process. Risk aversion skyrocketed, preventing any sort of meaningful rebound in USDJPY. A few months later, the vulnerable USDJPY pair rapidly turned lower once again on relatively benign, but yen bullish reports that the government had come up with a plan to fix the problematic banking sector. Over the course of the following week, the yen racked up an additional 13 percent in gains against the US dollar as the equity markets toiled in fear.
[B]USDJPY Daily Chart: Mid 1997-1998

Will the Yen Relive 1998?
Since February 27th, the US dollar has fallen over 5 percent against the Japanese Yen. While the combination of global equities in a selling frenzy and a massive amount of yen buying may warrant a bit of déjà vu for traders who felt the crunch in 1998, the situation is actually quite different now. First off, the liquidation was not crisis induced. Instead, the sell off of Chinese shares came the day after the Shanghai index had hit an all time high and was initiated by rumors that the government would impose harsh capital gains taxes on stock investments, which China vehemently denied. While equity markets around the world may indeed be a bit overbought and prime for a correction, the event was not triggered by something as severe as the default of a systematically important country like Russia.
Furthermore, as you can see in the chart below, rapid yen appreciation is not entirely uncommon for USDJPY as the currency has in the past, sustained hefty declines before and is subject to severe volatility from time to time. Each of the previous sell offs were triggered by either Yen positive comments from Japanese officials, negative US data or both. In the past 3 waves of Yen strength, the average move was 8.6 percent. Therefore even though we have a rebound in the Yen pairs at the moment, the downtrend could resume before the currencies bottom out. It will not however extend as far as the moves in 1998 and in fact, it will probably bottom out before the 13 percent move that we saw back in 2002. Looking ahead, Japanese officials may not be so quick to add fuel to the fire by talking up their national currency in fear that the markets will expect another near term rate hike by the Bank of Japan. They understand the negative impact that a stronger yen has on exports, which would only quell expansion for the economy as a whole. Finally, the repatriation of funds into Japan ahead of the close of the fiscal year on March 31 may only be able to provide so much lift to the currency as the deadline approaches.
[B]USDJPY Daily Chart 2002 – Present

But Be Careful of Higher CME Margin Requirements!

There is one major caveat however that could drive some sharp moves - On March 2nd, the CME increased the Initial Margin Requirement on several contracts by 25%, including Yen contracts, due to the spike in market volatility. Maintenance Margin Requirements for FX contracts in general were also raised by nearly 48%. As a result, traders who do not have the capital to meet these higher requirements could be forced to exit any remaining carry trades sooner rather than later, which could give the Yen an unintended boost. The Commitment of Traders report indicates that speculators are still very short Yen. Therefore, if USDJPY resumes its sell off, the breakdown at key levels could be exacerbated as futures traders get stopped out. The increase in volatility has made it more expensive to hold FX positions in the futures markets.
However even though we could see another leg lower before turn, given the minimal probability of policy tightening by the Bank of Japan in the near term, traders looking to get in on the massive bout of carry trade liquidation seen over the past week may have already missed the boat.