Carry on up the procyclical deleveraging  

Leverage can be bad for your health. Often, we can link deleveraging to most recent market selloffs, including the flash crash of early August. The Bank for International Settlements has outlined what it thinks happened, pointing to the seemingly innocuous jobs report from the US and a hawkish turn by the Bank of Japan, producing an unwinding of the popular yen carry trade and volatility spike. Such a big move – the Topix fell 12% in a single day and the VIX shot above 60, is down to “amplifying factors”, most notably deleveraging pressures amid thin markets.  

The strength of the move reflected a prolonged phase low volatility, which was conducive to the build-up of leveraged positions, such as currency carry trades and related strategies benefiting from low volatility. Hedge funds had been levering up and because the strategies required low volatility, it took only some relatively minor news to rock the boat. 

There had been signs of stress before August. A brief equity sell-off with some signs of carry trade unwinding occurred on July 24th. After what was seen as a hawkish pivot by the Bank of Japan and a more cautious approach to cuts by the Fed, investors decided that somewhat disappointing US labour market data on August 2nd implied a recession, implying policy was too tight. It was hardly an unequivocal sign of recession, but BIS notes that markets had become “hyper-sensitive” to signs of change in momentum. “Thus, the news acted as a catalyst for an equity market correction, with the S&P 500 losing 1.8%.” By Monday August 5th Japanese markets were in turmoil due to the carry trade unwinding and the S&P 500 lost another 3%. Markets stabilised almost as quickly as they had sold off. The flash crash didn’t last long and in this case markets proved resilient, but risk factors remain. 

BIS summarises thusly  

• Financial market volatility resurfaced in early August as the unwinding of leveraged trades in equity and currency markets amplified the initial reaction to a negative macro release in the United States. Markets then stabilised quickly, and volatility receded.   

• FX carry trades were hit hard by the deleveraging pressures. Their overall size is difficult to measure. Various estimates based on both on- and off-balance sheet activity yield a rough middle ballpark of ¥40 trillion ($250 billion) going into the event, which, if anything, is biased down due to data gaps.   

• The event was yet another example of volatility exacerbated by procyclical deleveraging and margin increases. Although an outright market dysfunction was averted this time, the structural features of the system underpinning such episodes deserve continued attention by policymakers 

Volmageddon 

With the initial rise in volatility, traders faced increased pressure to cover their leveraged positions through outright sales to meet margin calls or purchases of options and VIX futures, “further amplifying the rise in the VIX and the size of the volatility shock”. It is clear that the spike in the VIX far exceeded what should have been expected based on the historical relationship between the VIX and S&P 500 returns.  

Nickels and dimes 

The carry trade, involving as it does small but consistent returns in times of low volatility, but prone to incurring large losses when things change, is often likened to picking up nickels in front of a steamroller. Large FX carry trade positions were most sensitive to the volatility spike and were largely forced to unwind.   

“A well-established pattern is that spikes in volatility go hand in hand with deleveraging pressures and the unwinding of currency carry trades,” notes BIS. “There is also evidence that US equity volatility has become closely intertwined with currency carry returns. This common exposure is due to the fact that many equity option strategies entail implicit bets on volatility being contained, akin to currency carry trades.” 

Spillovers 

The impact of the unwinding reverberated across many currencies, reflecting the use of multiple sources of funding and investments by carry traders. The yen and the Swissy appreciated the most, being the most popular funding currencies. But other currencies were involved which are not typical in carry trade funding, most notably the offshore renminbi (CNH), which also appreciated notably. The Malaysian ringgit, illiquid and volatile at the best of times, gained even more, likely traded as a proxy for renminbi bets. Among the high-yielding investment currencies, the Mexican peso was hit hardest, followed by the Brazilian real and South African rand. 

Even crypto got swept up in the tsunami, which BIS thinks indicates retail traders faced margin calls and may have been forced to close positions even in seemingly unrelated assets. 

Rinse, repeat 

The worry is that none of these risks are going away. BIS notes that the actors behind the volatility spike and large market moves have not changed significantly.   

“Risk-taking in financial markets remains elevated,” says the report, which points out that only a portion of various trades that relied on low volatility and cheap yen funding appear to have been unwound; some other trades may yet need to be unwound more slowly; and that there are already indications that some leveraged positions are quickly being rebuilt.   

“More broadly, a number of factors behind the recent turbulence reflect structural features of our financial system, notably the greater heft of market-based finance,” warns BIS. “Of particular concern are the ones that enable the build-up of large positions in periods of calm and necessitate their quick unwinding when volatility rises. The reliance on leverage for many of these positions implies that investors will have to respond more strongly to adverse shocks to avoid significant losses. If such behaviour takes place in a jittery and illiquid market environment, volatility could be further exacerbated, and a negative feedback loop could be kindled. In addition, sudden (and large) changes in margins from derivatives and securities positions that are not directly linked to trades that rely on low volatility could add further pressure to markets, infrastructures and intermediaries.” [emphasis my own] 

Leverage can be a problem. But it’s not a bug, it’s in the DNA of our markets. 

Neil Wilson

Chief Market Analyst at Finalto

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