The article delves into the recent turmoil that has swept across global financial markets, a situation largely driven by the unwinding of highly leveraged trades. For months, investors had been riding a wave of optimism, fueled by large-scale bets on assets like the Japanese yen, cryptocurrencies, and major technology companies. These trades were characterized by the use of leverage—borrowed money that allowed investors to amplify their potential returns. As markets climbed through the first half of 2024, these leveraged positions generated substantial profits, attracting more traders to join in, which in turn pushed asset prices even higher.
However, the tide has recently turned. Over the past month, unrest has returned to global markets, and the same leverage that once magnified gains is now amplifying losses. Investors are being forced to retreat from these once-profitable trades, leading to sharp declines in asset prices and heightened volatility. Despite a temporary calming in the markets, with the Dow industrials still within 5% of their record high, there is widespread caution among traders. They warn that more upheaval could be on the way, especially as the process of deleveraging—where investors sell off assets to reduce their risk—continues to unfold.
The tumult in the markets can be attributed, in large part, to this deleveraging process. When economic or financial conditions change, investors are often forced to sell off one part of their portfolio, such as U.S. or Japanese equities, to cover losses from another, such as leveraged bets on a weakening yen. This messy process of reducing risk can take time, and it typically causes significant volatility in the markets. As Andy Constan, CEO of Damped Spring Advisors, explains, the deleveraging process needs to flush out those investors who are heavily leveraged and facing margin calls before new opportunities can emerge.
The timing of this deleveraging could not have been worse for the markets, coming as it did in the middle of the summer months when many traders and investors are on vacation. While much of today’s trading is automated, human decisions still play a crucial role, and with fewer professionals in the office, there has been a shortage of experienced individuals to manage the situation. This has led to thinner trading volumes and fewer investors willing to step in and buy as prices plummet, creating conditions ripe for panic. The article draws parallels to previous August market shocks, such as the 1998 collapse of Long-Term Capital Management and the 2007 “quant quake.”
In the past week, liquidity conditions have been dire, with some market participants noting that liquidity was as bad, if not worse, than during the Covid-19 market crash. The exact causes of these market tumbles are complex and multifaceted, but the deleveraging process has undoubtedly played a significant role. A slowing U.S. economy has also contributed to the volatility, but the rapid and severe market movements can largely be attributed to investors rushing to reduce their leverage—either voluntarily or after receiving margin calls from brokers.
One of the most striking examples of this deleveraging is the sharp reversal in bets against the Japanese yen. Hedge funds and other speculators, who typically rely on leverage, had been heavily shorting the yen, expecting it to decline further. These investors had been borrowing yen at low interest rates and selling it to invest in higher-yielding assets elsewhere—a strategy known as the yen carry trade. At its peak in July, hedge funds’ short positions against the yen were worth $14 billion. However, as the gap between U.S. and Japanese government bond yields began to narrow and the Bank of Japan raised interest rates, these trades began to unravel. Within days, these bets against the yen plunged by more than 80%, forcing traders to unwind their leveraged positions.
The pain hasn’t been confined to currency markets. Popular trades in U.S. technology stocks have also turned sour. For more than a year, hedge funds, quantitative funds, and other investors had piled into big U.S. tech stocks using borrowed money, often while betting against smaller-cap stocks. This strategy worked well until July, when lackluster earnings reports from tech companies, combined with a rally in small-cap stocks, led to sharp reversals. Over the past month, major tech stocks like Tesla, Amazon, and Nvidia have dropped by 15% or more, highlighting the dangers of heavily leveraged trading strategies.
The cryptocurrency market has also been hit hard. The first five days of August saw over $3 billion in forced liquidations as traders who had relied on borrowed money found their margin accounts insufficient to cover recent losses. Bitcoin prices fell by over 18% during this period, while Ethereum dropped by 24%. After spending much of the time since the collapse of the FTX exchange in late 2022 paring back their leverage, crypto investors began to ramp up again this year, spurred by the launch of U.S. exchange-traded funds holding bitcoin and Ethereum. However, this renewed optimism has been quickly tempered by the recent market turmoil.
The total dollar amount of outstanding bitcoin derivative contracts on centralized exchanges, a sign of the leverage in the system, reached $37 billion at the start of August, tripling from a year earlier. But the market mayhem on August 5th drove that total down to $28 billion. The volatility in the crypto market, like in the broader financial markets, has left investors bracing for more turbulence.
As investors look ahead, many are focusing on the upcoming U.S. employment report due on September 6th. A disappointing report could confirm the worst fears of those skeptical about the economy’s strength, potentially sparking another round of deleveraging. Conversely, a strong report could alleviate some concerns and show that July’s weak report was just an anomaly, possibly due to temporary factors like hurricanes.
John Lynch, chief investment officer at Comerica Wealth Management, advised his clients not to panic, underscoring the importance of staying calm during such volatile times. The situation remains fluid, and as the markets continue to adjust to the new economic realities, investors and traders will be closely watching for any signs of stability or further unrest.