There is an oft-used phrase from an old proverb that says, “you can’t have your cake and eat it too.” I thought of that proverb in early August when a small, but significant, subset of investors that had a “carry trade” (more on that below) learned that you can’t remain in possession of your cake while eating it.
Another way of understanding the proverb is what parents have told their kids for generations: don’t be greedy and take more than what you need or is reasonable.
Leverage, or the use of borrowed money to increase the potential return of an investment, is a double-edged sword. A levered investment can amplify returns to the upside, but it also comes with inherent risks; namely your losses are amplified on the downside (typically the downside is more painful than the upside). For a very long time, investors that implemented the “carry trade” were having their cake AND eating it too. The proverb, so it seemed, had met its proverbial match as investors borrowed money cheaply and poured the proceeds into a broad array of investments that kept going up in value… Until an action by the central bank of Japan caused capital markets to go into disarray, leaving those investors who thought they could have the best of both worlds wishing they had heeded the advice of their parents from long ago: don’t be greedy or unreasonable. We set out to explain the mechanics of what caused the volatility in capital markets in early August in the words below without boring you with the minutiae (however, if you have you children or grandchildren at home, we can almost guarantee that this will put them to sleep!).
At the beginning of August, markets around the world were impacted by what appeared to be a rather large leverage trade that is known as a “carry trade.” In this case, what investors were doing was borrowing in Japanese Yen (Japanese currency), which has experienced a very low interest rate environment, and then investing in everything from Japanese stocks, U.S. Government debt securities, and even the S&P 500 and other U.S. mega-cap tech companies. In order for this trade to be successful, investors would want their U.S. investments to perform well and the yen to stay weak. When the Bank of Japan increased interest rates by a mere 0.25%, the Japanese yen strengthened, and the returns of these levered trades reacted quite negatively. As the trades unwound and investors covered their losses, capital markets were impacted heavily to the downside. Japanese markets were down as much as 6% on Friday (8/2/24) and another 12% on the following Monday (8/5/24); its biggest one-day decline since the Black Monday crash in October of 1987.
The yen carry trade was one of the biggest carry trades that we have seen in over 30 years – one giant $20 trillion-dollar levered trade. These trades are very hard to time and when there is volatility in the markets, they can end up as sour investments (or bets if you are speculating). The use of leverage can feel like free money until it isn’t. When trades go bad, the use of leverage can make them much worse. Just as investors/speculators may have benefitted from leverage when AMC’s stock ran up like a SpaceX rocket, the other side of that trade was significantly impacted to the downside as well. There are two sides to every trade, and adding leverage into the mix amplifies the risk, as well as the return.
SDWMA would like to remind investors to be prudent when making investment decisions and to take into account all the risks an investment may have prior to putting an investment strategy in place. If you are interested in having a more in-depth conversation about your investment portfolio, please contact us at [email protected].
Article/Source: There’s no place like home | J.P. Morgan Private Bank U.S. (jpmorgan.com)
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Schneider Downs Wealth Management Advisors, LP (SDWMA) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). SDWMA provides fee-based investment management services and financial planning services, along with fee-based retirement advisory and consulting services. Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice. Registration with the SEC does not imply any level of skill or training.
