August’s volatility spike sparked widespread panic across financial markets and left many fearing that another global economic crisis was on its way. Although markets soon recovered, the Bank for International Settlements (BIS) warned that leveraged carry trades continue to pose a threat.
In its bulletin ‘The market turbulence and carry trade unwind of August 2024’, the Bank for International Settlements (BIS) reported that risk-taking in financial markets is still high, the majority of low-volatility, cheap yen-funded trades have been unwound (or are being unwound at a slow pace), and leveraged positions are already being rebuilt. With these underlying vulnerabilities still in play, the bank shared concerns that any market shocks could see volatility easily spike once again.
What happened?
A number of elements interacted in the early summer to create a perfect storm for yen carry trades. The summer saw a brief equity sell-off (24 July), along with rumbling concerns around AI and tech stocks and a subsequent US$1 trillion valuation drop. Following rumours of interventions from the Bank of Japan, depreciation in the yen reversed in the first half of July, altering the incentives for many leveraged speculators.
In FX markets, the yen, the predominant carry trade funding currency, appreciated. Traders that took a leveraged short position in yen faced margin calls, and closed out their trades in response.
In its bulletin, BIS highlights the potential of leverage to amplify market moves. “[This] hints at a key role of amplifying factors, most notably deleveraging pressures amid thin markets (as is common in August),” it stated. “The vehemence of the move reflects in part the prolonged prior phase of risk-taking amid unusually low volatility,” an environment encouraging a build-up of leveraged positions such as currency carry trades.
The following week, Japanese markets were faced with the unwinding of leveraged positions and carry trades, prompting a 12% decline in the TOPIX index, while the Nikkei volatility index spiked to crisis levels. Over the next few hours, other APAC markets reported volatility and losses before the hurricane made its way over to Europe and the US. Cboe’s volatility index (VIX) passed 60 in off-hours trading, the S&P 500 slipped another 3%, Eurostoxx dropped 1.7% and the MSCI Asia Pacific Index recorded its most significant drop in a year.
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Various funding currencies were caught in the carry trade unwind, BIS said, with the Swiss franc seeing a 3.5% appreciation compared with 6% for the yen as of 5 August. The crisis highlighted the impact on currencies that are not generally used in carry trade funding, including the offshore renminbi and the Malaysian ringgit, both of which saw notable appreciation. Investment currencies including the Mexican peso, the Brazilian real and the South African rand were all hit by the event.
As the VIX index shows, fear levels were high. However, by the end of the week the storm had abated. The S&P 500 recovered all its losses, TOPIX most of them. Although the fear index remained elevated, it was back to more normal levels by the end of the week.
“The spike in the VIX was associated with immediate deleveraging pressures,” BIS affirmed. An initial rise in volatility put pressure on market participants to cover their leveraged positions through outright sales to meet margin calls or options and VIX futures purchases, it explained. As a result, volatility continued to rise – in a spike which “far exceeded what should have been expected based on the historical relationship between the VIX and S&P 500 returns,” the BIS added.
The foundations for the crisis were laid long before this summer, BIS continued. Since the Covid pandemic, it said, Japan retail margin traders had mostly shorted the yen while trading volumes grew. As a broader set of positions by retail traders had to unwind, margin calls may have prompted the closure of positions “even in seemingly unrelated assets”, it explained, adding to the shockwaves of the event.
What now?
“Overall, markets showed substantial resilience in the face of considerable volatility. The speed of their recovery was remarkable,” BIS concludes. That being said, the events of this summer necessitate a look at structural instability in the financial system.
Market-based finance is a particular concern, BIS said, especially when this enables a build-up of large positions during low volatility and requires quick unwinding when fear levels spike. Relying on leverage for many of these positions encourages strong reactions to adverse shocks, it explained, which can lead to a vicious cycle of hiked-up volatility in a nervous environment and increase the pressure on markets, infrastructures and intermediaries.
©Markets Media Europe 2024
