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Stocks were smacked around Wednesday, with the S&P 500 recording its first 2%+ decline in forever, while the Nasdaq fell by 3.65%. It was just a rough day for risk assets all around. What we are in the middle of seeing at the moment, I believe, is the unwinding of the carry trade in the Japanese Yen globally, which has wreaked havoc on the volatility dispersion crowd and has now brought the CTA sellers back to life.

Name the currency, and the Japanese yen is strengthening by material amounts.

Japan was the only player in the developed world with sub-1% rates for the longest time. That game is over, and now worries are mounting that the BOJ may choose to raise rates next week. The problem is that the 10-year JGB now looks like it wants to go even higher from its current level of around 1.07%.

But with the 10-year JGB rising and potentially increasing, spreads between US 10-year Treasuries and 10-year JGBs are collapsing. Except that until July 8, the USDJPY was still rising despite the rate spreads moving lower, creating a considerable divergence. Now that the gap is closing, but based on the “jaws” that have opened, the USDJPY could have even lower to go.

So this creates a bit of an issue, and if the interest rate spreads continue to contract, the game is over and so is the yen short carry trade, which may very well mean the global equity market rally is over, too. Is it by chance that the move higher in the Yen and the Nasdaq 100 overlay nicely on a chart since the start of 2023?

Is it by chance that the Stoxx 600 in Europe and the EURJPY have traded so closely together over the same time? I do not have the answers, but it tells us that we better pay attention because it is, and there is a chance this unwinding process is closer to the beginning than the end. If the Fed is on the eve of a rate-cutting cycle, the BOJ is not only continuing to push rates up but also pulling back from its bond-buying programs; these rate spreads will have much further to contract.

However, shorting the yen, and buying the Dollar, Euro, Aussie dollar, you name it, to buy stock sure sounds like a really cheap way to lever up.

The bigger problem is that the market was so heavily skewed bullishly that nobody was positioned for a sharp sell-off, as per the 1-month implied correlation index closing below three on July 12, while realized volatility entered the land of the stupid levels. Now, the 1-month implied correlation index is back over 15. That is why they say the escalator up and the elevator down; things just happen much faster when the deleveraging process starts. But even at 15, this thing is way too low and probably goes higher from here as the seasonal effects of the volatility dispersion trade unwind.

Meanwhile, the S&P 500 is approaching the lower end of the rising wedge pattern, and the 50-day moving average is probably the level to watch for that. A meaningful break of the 50-day moving average signifies a broken uptrend off the October low and, more importantly, a rising wedge that has broken to the downside, complete with a throw-over, from the rally at the start of July.

So yes, lots of stuff is happening, and there is too much to write up tonight—more tomorrow.

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