The big ‘carry trade’ unwind is far from over, strategists warn

It’s too early to give the all-clear to the rapid unraveling of “carry trades,” strategists have said, warning investors that the unwind may still have further room to run.

Carry trades refer to operations wherein an investor borrows in a currency with low interest rates, such as the Japanese yen, and reinvests the proceeds in higher-yielding assets elsewhere.

The foreign exchange strategy has been hugely popular in recent years, particularly as investors expected the Japanese yen to remain cheap and for Japanese interest rates to remain low.

However, the yen-funded carry trade began aggressively unwinding last week, as interest rate hikes by the Bank of Japan strengthened the yen — and led to a dramatic sell-off in global markets.

Richard Kelly, head of global strategy at TD Securities, said he’d be “very hesitant” to declare the end of the carry trade unwind, despite suggestions from some economists that the roll back may be largely complete.

“I’d push back on a lot of those narratives. You don’t have any real data to price your carry trades that we know,” Kelly told CNBC’s “Squawk Box Europe” on Monday.

“I think there is still a lot that can unwind, especially if you look at how undervalued yen is. That is going to change the valuations for the next one to two years to come. That’s going to have spillover effects.”

Economists have said it is difficult to accurately assess the scale of the yen carry trade, with estimates varying widely. Some analysts, using Japan’s foreign portfolio investments, say the yen carry trade could total as much as $4 trillion, Reuters reported.

Analysts at TS Lombard, however, said in a research note last week that investors may need to find up to $1.1 trillion to pay off yen carry trade-borrowing.

“If you look at our models right now, similar to some of the sentiment you’re seeing in the market, they are telling you that you should be buying back into the carry trade. You should be buying into MEX and Brazil and some of these higher-yielding assets [and] start shorting some of the funder currencies,” Kelly said.

“I think that’s probably wrong. I think there is a structural change. The [Bank of Japan] is still going to need to tighten, the yen is still fundamentally undervalued, the Fed is starting to ease — which is going to change some of these interest rate differentials in the wrong direction,” he continued.

“So, I wouldn’t be buying back into some of these high-yielding [emerging market] assets. I would probably be looking to go long yen, still in sort of long dollar environment. I think that is the right trade, but it is structural rather than sort of near-term high frequency data.”

Kelly’s comments come as market participants brace for key U.S. inflation figures in order to get a better picture on the health of the world’s largest economy.

The U.S. producer price index, a measure of wholesale prices, is scheduled for release on Tuesday and the consumer price index will be released Wednesday. The readings could prompt the Federal Reserve to begin cutting interest rates from next month.

A sharp sell-off in risk assets last week was partly driven by weaker-than-expected U.S. economic data. The figures led investors to worry that the Fed may be behind the curve in cutting interest rates to fend off a recession.

“I actually think that the massive and violent correction that we got last week was actually quite healthy because it forces investors to focus on what’s the real Japan strategy,” Jesper Koll, expert director at Monex Group, told CNBC’s “Squawk Box Asia” on Tuesday.

“The real Japan strategy is not just a quick carry trade, borrowing at close to zero interest rates in Japan and investing in high yield assets. The real Japan investment trade is the benefit of corporate restructuring, the first sustainable growth in real wages now coming through. So, focus on the domestic economy rather than the froth economy that came about with zero interest rates,” Koll said.

Analysts at Barclays said systematic selling pressure does not appear to have been exhausted yet and it’s “too early” to call an all-clear to the carry trades unwind.

“Investors will likely remain on edge over the weeks ahead, with liquidity set to remain thin and risk allocations light. We expect volatility to remain elevated, which should continue to hurt EM carry trades,” the analysts at Barclays said in a research note published Sunday.

“We would not recommend fading this move in EM rates just yet and see selective opportunities given the uncertainties about the US economy,” they added.

Not everyone is as concerned about the long-term impact of the carry trade unwind. Some economists believe most of the immediate disruption from yen-funded carry trades has been played out.

“Our base case remains that the recent run of poor data is more likely down to temporary disruption than the start of a serious slowdown, which suggests to us that the recent rebound in risky assets and currencies will continue,” Jonas Goltermann, deputy chief markets economist at Capital Economics, said in a research note published Friday.

“As for the much-discussed yen carry trade unwind, our sense is that most of the immediate disruption on that front is now in the past, but we expect the yen to hold on to its recent gains and, probably, make further headway over the coming months and into 2025,” Goltermann said.

— CNBC’s Michael Bloom and Dylan Butts contributed to this report.