In the past two weeks, the global markets have experienced tumultuous ups and downs, largely driven by carry trade strategiesFollowing two consecutive days of panic selling that led to a market crash, a return to calm has ensuedMarket participants and institutions generally view this as a fleeting episode of hysteria, instigated by a slight policy adjustment from the Bank of Japan and renewed concerns over a potential recession in the United States.

The abrupt nature of this crash, quickly followed by recovery, has revealed a disturbing vulnerability within the market; it is easily swayed by popular trading strategiesHedge funds have capitalized on these strategies by financing bets amounting to hundreds of billions of dollars across nearly every corner of the globe.

Among the most notorious strategies is the carry trade involving the Japanese yen, a perennial favorite among traders seeking profit

This method typically involves borrowing in Japan, where interest rates are notoriously low, and investing in higher-yielding assets such as Mexican bonds that yield over 10% or fast-growing stocks like NVIDIAThe continued depreciation of the yen serves to lower repayment costs for these loans while simultaneously magnifying returns on investments.

For instance, consider a carry trade that involves borrowing in yen to invest in Mexican securitiesJust last year, such a strategy boasted a return of 40%. This trend shows no signs of abatingAs of early July this year, a basket of eight emerging market currencies funded by yen investments reaped returns exceeding 17%.

As countries globally sought to mitigate the soaring inflation stemming from the recovery post-pandemic, other central banks began to shift their policies to combat rising pricesThis provided additional motivation for speculators to borrow in yen, as global interest rates climbed while the Bank of Japan maintained its benchmark rate below zero, thereby widening the profitability for carry trades.

However, an unexpected twist occurred when the Bank of Japan raised its interest rates for the first time in 17 years

• OPEC+ Delay: What Lies Ahead for Oil Prices?
• Gold Weakens and Declines
• Gold & Silver: Volatile Ahead of Non-Farm Payrolls
• Hedging Options as Bitcoin Breaks $100K Barrier
• Coal Power's Low-Carbon Shift: External Aid & Internal Upgrades

While the current benchmark rate is a mere 0.25%, the lowest among developed nations, this increase has prompted investors to reassess the traditional carry trade strategyThe significant question arises: can Japan's borrowing costs consistently stay near zero?

This uncertainty prompted traders to liquidate holdings to meet margin calls, further contributing to a robust rebound of the yenThis widespread liquidation wreaked havoc across the Japanese stock market, with the Nikkei index plummeting a staggering 12% in one day, marking the most severe single-day sell-off since 1987. The fear was palpable—what if the strengthening yen stifled exporters, who are vital to Japan’s economy?

Currently, noteworthy signs are emerging in the market, with data indicating that hedge funds have begun to retract some of their bullish bets on the yen's continued appreciationAlthough the market's prior tumult due to yen fluctuations appears to have stabilized, the incident has sparked heightened vigilance regarding Japan's leverage ratios across various sectors

In the wake of the pandemic, the Bank of Japan has been relentlessly injecting cash into the market amidst soaring inflation, which undeniably compounds market uncertaintyUnder these conditions, traders are ensnared in a cycle of anxiety, fervently attempting to gauge whether most of the recent unwinding activities have concluded or whether these unfinished liquidation processes will continue to sway market direction and instigate new volatility in the weeks aheadAfter all, the trajectory of unwinding activities has significant implications for market liquidity and asset pricing.

According to data from GlobalData TS Lombard, it could be speculated that if Japan utilized all its overseas borrowings since the end of 2022 to finance its expenditures and domestic investors leveraged their positions for foreign purchases, this strategy could sum up to an investment of about $1.1 trillion.

In the aftermath of last week’s dramatic unwinding, JP Morgan has estimated that three-quarters of the world's currency carry trades have unwound

Concurrently, analysts at Citigroup remarked that the current positioning levels have transitioned the markets out of what they termed the “danger zone.”

Some financial institutions, after thorough analysis, predict that the downtrend of the USD/JPY pair may have significant room to extendThey project that the exchange rate could plummet to as low as 100, marking a decline of over 30% from last week's closing levelSuch forecasts highlight the yen's potential for robust appreciation; should this scenario unfold, further liquidation of carry trades seems inevitableThe sudden strength of the yen last week inspired extreme panic-driven movements within the marketHowever, given central banks' cognizance and governance of the markets, it is unlikely that similar extreme conditions will reinstate themselves anytime soonNonetheless, as countries worldwide continuously adjust their interest rate policies, substantial market fluctuations may still recur intermittently.