The carry trade as risk driver

August 04, 2024 at 13:18 PM EDT

Preface: Explaining our market timing models We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.
The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don't buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:

Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)*
Trend Model signal: Neutral (Last changed from “bullish” on 26-Jul-2024)*
Trading model: Bullish (Last changed from “neutral” on 25-Jul-2024)*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.

Subscribers can access the latest signal in real time here.

Watch the Yen
Even as equity markets turn risk-off, the real driver of risk appetite may be coming from cross-asset considerations and determined by hedge fund risk management policy. The combination of a hawkish shift in BOJ monetary policy and an easier tone to Fed policy has forced an unwind of the Yen carry trade. For the uninitiated, carry trades are where a investor borrows in a low yielding currency such as the Japanese Yen and invests the proceeds in a high yielding one. Since the yields spreads are relatively small, hedge funds take on carry trades with leverage, and lots of it. A carry trade unwind forces carry traders to flatten their positions. As the positions are taken on with leverage, a rush for the exits by leveraged traders is exporting cross-asset volatility to the rest of the hedge fund’s book, which forces a de-risking and deleverage of other asset classes. That’s how disorderly panic sell-offs happen.
Is the panic over? From a technical perspective, both the 10-year Treasury-JGB yield spread and the Japanese Yen are testing the support zones, which may serve to stabilize asset prices as the USDJPY consolidates in the support zone.

The full post can be found here.