NEW YORK: Investors said the aftershocks of a massive carry trade that has reverberated through global financial markets wasn’t done yet, with more unwinding in the days ahead raising the risk of shake-outs to other assets. The Nasdaq Composite and the S&P 500 trimmed losses by the close on Monday, capping off a brutal three-day selloff while Tokyo markets rebounded from a similar rout in trading on Tuesday.

The massive selloffs had come after a higher-than-expected US unemployment rate on Friday sparked worries the US economy was heading for a recession. Concerns about the markets were exacerbated by investors winding down yen-funded trades that had been used to finance the acquisition of stocks for years after a surprise Bank of Japan rate hike last week. The so-called ‘carry trade’ is commonly used in currency markets where investors borrow money from economies with low interest rates such as Japan or Switzerland, to fund investments in higher-yielding assets - this time stocks - elsewhere.

Despite the easing off in selling, investors were worried about more volatility ahead. “We expect the sell-off to continue for maybe a few more days as usually these... trades are pretty large,” said Zhe Shen, head of diversifying strategies at TIFF Investment Management. “People said ‘wait, we’re losing too much money from unwinding. Let’s just hold and we’ll unwind some more tomorrow.” The complete unwind of this yen-funded trade is likely to take days, potentially extending the market rout, Zhe said. “There’s tons and tons of yen carry trades that still have to be closed out,” said Ulf Lindahl, CEO at institutional investors advisory firm Currency Research Associates.

Investors are still scrambling to figure out the size of those trades and how much of the cheap funding was deployed in equities. Calculations made by hedge fund research firm PivotalPath show that hedge fund strategies most affected by a yen rally are global macro quantitative and managed futures, as they have short exposure to the Japanese currency. A spike in the yen this month indicates a loss of between 1.5 percent and 2.5 percent in August for those funds’ indexes, according to the firm’s exposure model.

“It’s very, very hard to know what the actual size of those positions are and how much is hedged and how much isn’t hedged, and therefore how much pressure is on,” said Kathy Jones, chief fixed income strategist at Schwab. “When you get hedge funds that are leveraged, and maybe there are derivatives involved, you get a pretty sizable reaction.”

Some money managers or trading strategies had already been reducing risk in the past few days. “Momentum certainly has been unwinding quite a bit in the past few days, and that’s cutting across all asset classes,” said Mike Gleason, director of equity alternative strategies at Acadian. “So, you have this response mechanism of multiple asset classes responding in kind.”

Steve Sosnick, head trader at IBKR Securities Services, said trading Sunday night and on Monday’s open “had the feel of forced selling.” “There was a certain ‘get me out’ quality to the pre-market and opening trades that since have subsided,” said Sosnick.

Hedge funds started unwinding risk roughly two weeks ago, when stocks started to fall. Morgan Stanley estimated on June 25 that macro hedge funds could sell $110 billion in the coming weeks if markets further deteriorated. For some investors, the fact that the Nasdaq fell 10 percent below its record of 18,647.45 points on July 10 poses another challenge for a quick and sustainable bounce back.

“Most of the people haven’t unwound anything yet because they think it’s just a regular correction,” Currency Research Associates’ Lindahl said. “This is a serious thing, it’s not just the regular correction. You don’t have gap openings for 4 percent or 5 percent in major indexes, and then they recover. There’s a serious collapse that’s coming.” On Monday evening, US indexes futures opened in the black, pointing to investors taking advantage of lower valuations. — Reuters

“We’re seeing fair number of people who are looking to be buyers on this setback. I think that’s probably going to give us more of a two-way market,” said Schwab’s Jones. – Reuters