(Bloomberg) -- An unwinding of global carry trades is helping to jolt markets around the world.
The yen and yuan pushed higher Monday, while the Mexican peso extended its decline as traders continued to roll back the popular trading strategy. The peso pared some losses to trade 2.3% weaker to the greenback, the worst performance among currencies tracked by Bloomberg, while the Australian dollar was down 0.7%.
The moves came as a selloff in risk assets intensified with markets including stocks and cryptocurrencies pummeled as concerns grew that the Federal Reserve is behind the curve with policy support for a slowing US economy. Investors sought the safety of bonds.
The sudden appreciation in funding currencies has damaged the strategy that typically involves traders borrowing at lower rates to invest in higher-yielding assets, often in the emerging world but also in developed markets like Australia.
“This is a carry trade liquidation still in the FX space and a race to cash across asset classes,” said Brad Bechtel, global head of FX at Jefferies LLC. “One heck of a deleveraging is taking place now and with the market so unhinged it’s hard to call a bottom just yet.”
Two currencies often used to fund carry trades jumped — the yen by about 3% and China’s yuan by 0.8%.
Worries about US recession risk are bad environment for carry traders, according to Alvin Tan, head of Asian currency strategy at Royal Bank of Canada in Singapore. Thin markets in the northern hemisphere summer may also be playing a role, he said.
“August volatility spikes can be very dangerous because liquidity tends to be low in the month,” he added. “August is a popular vacation time in North America and Europe, so even if things start to stabilize, I’m not sure investors are going to be keen to put on trades quickly.”
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Yen-funded carry trades were among the most popular in emerging markets as volatility remained low and investors bet Japanese interest rates would remain at rock bottom. But the Bank of Japan raised rates for a second time at its latest meeting and signaled the potential for more.
“The rise of Japan interest rates is changing the game rules,” said Pierre-Yves Gauthier, head of research at Paris-based brokerage AlphaValue. “In essence it’s the end of a free resource.”
Meanwhile, traders eyed the Chinese yuan as a funder given bets the currency would weaken amid concerns over the nation’s economy.
Year-to-date returns in a basket of emerging market currencies funded by the yuan turned negative on Monday, while the gain in yen-funded trades came closer to being erased, according to data compiled by Bloomberg.
The closing of short yen positions represents a “real structural issue” with investors realizing they will have to pay a positive interest rate and unwinding the trade as Japan is expected to raise interest rates at least one more time this year, according to Christopher Dembik, senior investment adviser at Pictet Asset Management.
“The issue at stake is not so much the market movement, it’s the scale, we’re talking about of sums which are enormous today on the carry trade,” he said. “Of course, all the carry trade won’t be unwinded in a day but given the scale, it creates structural problems.”
--With assistance from Marcus Wong, Daisuke Sakai, Julien Ponthus and Peter Laca.
(Updates with fresh market prices in second paragraph, new comments starting in fifth.)
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