CICC: New Issues in Covered Interest Rate Parity Trades and Liquidity Shocks

Monday saw a rare 12.4% plunge in the Japanese stock market (the largest single-day drop since Black Monday in 1987) and the continued 2% appreciation of the Japanese yen. This brought last Friday's "recession worries" trading, which was largely based on fundamentals, to another level, namely a partial liquidity shock. Obviously, this decline cannot be solely explained by fundamentals. In other words, aside from fundamentals, the market's decline itself has become a problem.

Why the sharp drop? Reversal of the yen carry trade, exacerbated by emotional selling

The so-called carry trade refers to investors borrowing low-interest Japanese yen funds and investing them in other markets. While the recent 15bp rate hike by the Bank of Japan did increase financing costs, the market's expectations were already priced in and not significant, so the Nikkei index still closed higher that day. However, when the U.S. stock market fell last Thursday and Friday due to disappointing ISM and non-farm payroll data triggering recession concerns, the situation changed. Losses on the asset side and rising costs led to a reversal, manifested in the strengthening of the yen exchange rate. Additionally, risk aversion, volatility in U.S. tech stocks, and yen appreciation all impact the Japanese stock market, leading to a sharp drop in Japanese stocks.

Chart 1: Disappointing non-farm payroll data triggering recession concerns

When faced with this situation, investors typically "sell first and ask questions later," rendering any position and fundamental analysis powerless in the face of emotions and panic selling. This is a typical pattern seen in every market fluctuation.

Market volatility enters a phase of partial liquidity shock

If last Friday's trading was still focused on whether the market was overly concerned about a recession at the fundamental level, the volatility in the Japanese stock market and the yen carry trade on Monday have pushed market volatility into a new phase of partial liquidity shock. In this phase, disregarding fundamental issues, the market's decline itself becomes a problem With such a significant decline, it is likely to trigger some liquidation or even forced liquidation. Whether there is a large amount of leverage behind it, or even transmitted to derivatives or risk exposure of other financial institutions, triggering further liquidation, we do not know yet, but all of these will increase short-term volatility.

A global USD liquidity shock generally manifests as a stronger USD, higher OIS and commercial paper spreads, and offshore USD tension (sharp rise in exchange rate swaps). For example, during the epidemic, there was a period of USD strength, and extreme situations where safe-haven assets such as US treasuries and gold plummeted, because risk control and position risks triggered a cash flow (USD) demand, causing all assets except USD to fall. Currently, we have not seen these yet, so the preliminary conclusion remains at a localized liquidity shock, such as the UK pension fund default in October 2022, Silicon Valley Bank, and later Credit Suisse default situations.

Chart 2: OIS tends to strengthen during general liquidity shocks

Chart 3: Currency swaps have not widened yet

How far has the trading progressed? Emotionally, it has become quite extreme

From a technical perspective, the Japanese stock market is already heavily oversold, with the Nikkei index RSI reaching 17.7, a new low since the 2020 epidemic. The overbought level of the Japanese yen has also hit a new high. Speculative positions in the Japanese yen CFTC market still remain mostly bearish, but net shorts fell by 29.1% in the single week from July 23 to 30, with shorts quickly covering. Japanese stock valuations have quickly returned to around 18 times, slightly higher than the average level since 2014. The US stock VIX index is at 42.7%, also a new high since the epidemic. Therefore, considering these indicators collectively, market sentiment has been significantly relieved.

Chart 4: Nikkei RSI reaches 17.7, a new low since the 2020 epidemic

Chart 5: The overbought level of the Japanese yen has also hit a new high

Chart 6: CFTC speculative net short positions fell by 29.1% from July 23 to July 30 in a single week, with shorts quickly covering

Chart 7: The US stock market VIX index is at 42.7, also a new high since the epidemic

Chart 8: Japanese stock valuations have returned to around 18 times, slightly higher than the average level since 2014

How much room is left for the unwinding of carry trades?

First of all, it is difficult to accurately obtain the explicit size of carry trades (looking at the interdepartmental borrowing and lending scale of foreign banks in Japan, the data as of May is roughly around 10.7 trillion yen; measured by BIS statistics, the scale of cross-border debt denominated in yen borrowed from Japan is roughly around 1 trillion US dollars), not to mention other implicit channels. Secondly, even if we use the above scale as a reference, it is difficult to completely assume to what extent the unwinding of carry trades can be considered cleared, as this is closely related to investor sentiment and the chain reaction of trading. Assuming we use the observation window of the scale of interdepartmental borrowing and lending of foreign banks in Japan (there are inevitably other channels and methods), with the stock scale as of May being 10.7 trillion yen, assuming a need to return to the low point of 6.1 trillion yen at the beginning of 2022, the scale that needs to unwind is 4.5 trillion yen, which is roughly equivalent to the daily turnover of 5.1 trillion yen of the Nikkei Index on Monday. However, the deficiency of this data is also quite obvious, with incomplete statistics and time lag.

Chart 9: Looking at the interdepartmental borrowing and lending scale of foreign banks in Japan, the data as of May is roughly around 10 trillion yen

How to stabilize fluctuations caused by liquidity? Policy intervention is necessary and effective

Liquidity shocks generally require policy intervention (verbal statements or actual support) because failure to intervene may trigger larger chain reaction shocks. Liquidity shocks are not balance sheet issues, so policy interventions generally work and may even quickly regain lost ground from previous periods, as seen in the UK pension in October 2022, Silicon Valley Bank in March 2023, and the subsequent collapse of Credit Suisse Japanese Finance Minister Toshimitsu Suzuki has stated that he is already paying attention to stock market fluctuations [1]. In addition, whether the Bank of Japan will resume ETF purchases, statements from Federal Reserve officials, and Powell's speech at the Jackson Hole central bank meeting are all changing factors. In contrast, while natural liquidation can achieve the goal, panic and position stampedes may trigger contagion risks.

So how to roughly judge the short-term downside space? Since it is no longer purely a fundamental issue, a rough estimation method is to use indicators that are suitable for emotional trading. Some of the technical indicators and key support levels mentioned above are crucial for short-term judgment. If they are not broken, the position can temporarily stabilize. Generally, a breakthrough will lead to further amplification of programmatic and quantitative trading, meaning the need to find the next support level. Similarly, the weekly support line for the Nikkei is around 31,000 points, which was reached after a big drop on Monday. The next key support levels for the Nasdaq and S&P 500 are around 16,100 and 5,100 points, respectively.

Outlook for the future? Increased liquidity volatility, but fundamentals remain the underlying logic

Based on the fundamental basis of the above judgment, there is still no systemic concern about recession, which is also one of our basic assumptions. Therefore, market volatility mostly remains in the stage of being overly crowded and overly profitable, amplified by "recession concerns" and the liquidity issues analyzed above. The main reason for this judgment is that there are no obvious problems with the balance sheets of the private sector, and the squeeze of financing costs on investment returns is not significant (meaning that monetary easing can easily stimulate demand improvement, which was the main reason for the market's expectation of the Fed rate cut at the end of last year, pushing down US bond yields and driving the recovery of US real estate and investment).

If it is not a systemic fundamental and balance sheet leverage issue, short-term containment of liquidity shocks will bring better rebound opportunities. Conversely, if it is a systemic fundamental and balance sheet issue, where monetary policy easing and liquidity supply cannot solve the problem, debt resolution and direct fiscal intervention are needed.

Chart 10: After all, liquidity shocks that are not balance sheet issues generally require policy intervention, which generally works

Authors: Liu Gang, Li Yujie, Yang Xuanting, Source: [CICC Insight](https://mp.weixin.qq.com/s?__biz=MzI3MDMzMjg0MA==&mid=2247739828&idx=1&sn=015a5ab74204412a6cfcbd48d22c66ab&chksm=ebb6b9cc2a5e9eb4456a07d3ec189c3a47cb7e9292c74205ba37b9961f29dc90c1d03debcc06&mpshare=1&scene=23&srcid=08064LePCWvb6WCY4fUYNmw5&sharer_shareinfo=b33373026fd85f89cdd2ab0b20f57417&sharer_shareinfo_first=b33373026 fd85f89cdd2ab0b20f57417#rd), original title: "New Issues in Carry Trade and Liquidity Shock"

Liu Gang, CFA Analyst SAC License No: S0080512030003 SFC CE Ref: AVH867

Li Yujie Analyst SAC License No: S0080523030005 SFC CE Ref: BRG962

Yang Xuanting Analyst SAC License No: S0080524070028