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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Good morning. What looked like a recovery in US stock markets yesterday became a decline by the end of the day. Whatever problem we have been having, we are still having it. Send us your diagnosis: robert.armstrong@ft.com and aiden.reiter@ft.com.
The carry trade reconsidered
Everyone loves a simple phrase that covers a complex phenomenon — even more so if it sounds a bit sophisticated. Enter “the carry trade”, or, even better, “the unwinding of the carry trade”, which have been rolled out as an explanation for all sorts of market chaos in the past week or so.
We’ve written that we see no evidence that the volatility in US equities, in particular, results from the carry trade. It seems more likely that causality runs in the other direction. After talking to people who understand currency markets and Japanese finance better than we do, we still think this.
Defined most loosely, a carry trade is just using capital from low interest rate countries to buy high-yielding assets elsewhere. This covers all the Japanese institutions and households who have used a cheap yen to invest abroad. Some of this flow may reverse if Japan’s rate differential with the rest of the world continues to close. But that is not what is happening now. Here is James Malcolm at UBS:
Japanese outflows have been largely in the form of foreign direct investment . . . [after the Bank of Japan raised rates] they did not fundamentally alter their risk appetite — Toyota is not closing its factories. They are investing abroad for growth and access to labour. And Japanese [institutional] investors are similar. When they buy foreign equities, it is for earnings growth and diversification. They may have sold off some foreign AI holdings, but it is unlikely that they will start to repatriate in a big way. And Japanese retail investors in particular have few assets offshore.
Defined more narrowly, the yen carry trade is currency desks and hedge funds borrowing yen to invest in other higher-yielding currencies or fixed income products. Malcolm at UBS estimates that since 2011 there has been a cumulative $500bn in dollar-yen carry trades. And the leap in the yen and fall in higher-yielding currencies suggests that the dollar-yen carry trade and some of these other yen carry trades really did unwind:
These trades tend to blow up for two reasons. First, when there is a change in interest rate differentials which make the trade unprofitable. There has been a slow walk away from yen carry trades since March, when the BoJ raised rates out of negative territory. A rush for the exits based solely on the BoJ’s 15 basis point increase last Wednesday seems quite odd.
The second type of trigger is a volatility shock. From Mark Farrington, global macro adviser at Farrington Consulting:
[A volatility event] pushes [traders] to downsize their FX carry positions . . . inputs to the risk management model will be generalised volatility indicators, not necessarily only FX volatility. Large losses in your US equity trades that are dollar funded can still force risk adjustment in your yen funded trades, and vice versa.
So the equity sell-off could have triggered the unwinding of the carry trade, not the other way around. And the timing suggests this is what happened. The equity sell-off did not start in earnest until Friday of last week — two days after the BoJ raised rates, or after currency traders had time to digest the news.
Markets being markets, after the equity sell-off triggered the unwinding of the yen carry trade, the carry trade unwind could have then exacerbated the equity sell off — especially since everyone kept shouting “carry trade!”. But they are separate phenomena, and while the yen carry trade (narrowly defined) seems likely to continue unwinding, that alone does not necessarily imply that global equities must remain under pressure.
(Reiter)
Can copper be a long-term investment?
In the middle of September last year Unhedged wrote about copper. The argument was that the green transition — if it actually takes place — will require a lot of copper for electric vehicles and new power grids, and the outlook for new copper supply does not look deep enough to meet what is needed. Believers in the transition should therefore have exposure to rising copper prices.
Our column made us feel clever. The price of copper rose by more than 25 per cent between September and May, and the stock price of Freeport-McMoRan, the leading copper miner, rose 40 per cent. But, like so many things that make journalists feel clever, the trend did not last. Since the May peak, the price of copper has retraced almost all of its gains.
As FT colleagues wrote last week:
Flagging Chinese demand [have prompted] fund managers to cut around $41bn of bullish bets on natural resources.
The sell-off in copper . . . has been particularly stark — it is down close to 20 per cent from its record high in May above $11,000 per tonne . . . Traders’ bullish positions — net of bearish bets — on commodities have dropped 31 per cent, or $41bn, from a late May peak of $132bn to July 30, according to data from JPMorgan . . .
Much of the copper bought by China in the first half of this year ended up being stockpiled, rather than used.
Manufacturing industries are in contraction worldwide. China’s housing market has not recovered as hoped. And copper’s AI narrative — the idea that data centres will require lots of it — may have been overblown.
Meanwhile, the long-term case for copper is unchanged. All we have learned is that price volatility and carrying costs make that case very hard to invest in. Jeff Currie, a commodities strategist at Carlyle and former Goldman Sachs commodities chief, thinks another copper supercycle is coming. But, as he argued in a recent note, a change in the structure of the market has made it harder than ever to bet on:
What makes this time different from the previous cycle in the 2000s is the reduced capacity for the market to hold long-term risk on behalf of these industries, which means the investment in commodities to meet this rise in investment demand will need to wait longer until the environment is far more certain.
Post financial crisis capital rules radically reduced the amount of capital that banks would risk in commodity futures markets, making those markets thinner and less reflective of fundamentals. Furthermore, the macro hedge funds that played a big role in commodities markets 10 or 20 years ago have been replaced by algorithmic traders, momentum chasers and “pod” funds with low risk limits. The price impact of supply/demand imbalances are therefore not felt until the imbalances have actually arrived. As Marcus Garvey, Macquarie’s head of metals, told Unhedged: “We have to accept that commodity markets are in a sense still spot markets. They are not really discounting the future.”
For copper investors who are willing to bear the volatility of a myopic market while waiting for the green transition trade to pay off, owning mining equities is the only viable trade. It is the only one with a positive carry. But one wishes that carry were higher: Freeport’s dividend yield is under 2 per cent and its free cash flow yield is less than 3 per cent. Other miners offer better yields, but are higher-cost copper producers or have more exposure to other metals. One consoling thought: the market may well offer more appealing points of entry to the copper trade if the economic slowdown gets worse.
One good read
“If you really want to know something about solitude, become famous.”
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