Imagine There’s No Carry, It’s Easy If You Try

By Peter Tchir of Academy Securities

What were we thinking about markets last weekend?

In some ways, that seems like an obvious question, since the S&P 500 finished the week unchanged!

On the other hand, it might seem like a crazy question, since you heard more about the yen carry trade than you ever wanted to hear, and saw stocks decline sharply on Monday (with lots of “crash” chatter), only to be followed later in the week with the best day for the S&P 500 since 2022.

Despite last week’s volatility, it seems easiest to start with where we were last weekend.

The Plodding Fed. We focused largely on how the Fed seems to be basing policy on some data of dubious quality (birth/death model on jobs, and OER on inflation). We stuck to our theme that very little de-risking had occurred and more pain was to come (we also paid some attention, though clearly not enough, to the yen carry trade). It is worth pointing out that on Wednesday of the prior week, the S&P 500 was up over 2% after the FOMC, so, yes, this week’s rally was impressive, but we had a similar one before and it didn’t prevent the “excitement” of this week.

We think that last weekend’s report is relevant, and worth reading if you didn’t get to it before the “fun” began on Sunday night.

Sunday night saw the yen gap stronger, and stocks, stock futures, and crypto drop significantly. By Monday morning, the weekend T-Report had to be supplanted with Margin Call Monday. We did our best to analyze what was going on in markets. Without a doubt, we finally had some serious de-risking.

Turnaround Tuesday fizzled, as did another bounce on Wednesday, but Thursday had no such problem as apparently, at least in part, a small (probably statistically insignificant) drop in new unemployment claims combined with some strong earnings sent stocks soaring. As we wrote on Thursday, that rally was unlikely to fade, as even my mother knew that every rally faded, and that is usually a good contrarian signal.

But that leads me to the question, and the main reason for today’s title, how much did market positioning change?

Imagine There’s No Carry Trade, It’s Easy if You Try

One thing that I think we can safely argue is that there is very little positioning left in the yen carry trade. Anyone who didn’t get stopped out by now is unlikely to close out trades unless we get another monster move. It seems difficult to believe that much money was put to work creating new yen carry trades even at the now “attractive” levels and with a “pledge” from the BOJ not to raise rates while markets are volatile.

So, one difference is this yen carry trade has largely been removed from the system and has not been replaced. That is good for risk and for calming markets.

How Much De-Risking Occurred in the “Panic”

That is really the biggest question of all. Bulls seem to be of the opinion that we had “panic,” and the market is all set for clear sailing from here.

We concede that the yen carry trade should no longer be an issue. On the other hand, I would argue that there was very little panic as a whole. We focused on the alleged panic in Did the VIX Hit 65?

We argue quite vehemently (and hopefully convincingly) that there was no panic in the volatility markets. Fear, yes. Some new hedges added, yes. But panic, no. We focus on the VIX futures market, since it actually trades, and people actually risk money in the VIX futures market, unlike the VIX calculation, which is just that, a calculation (a complex and sometimes, like Monday morning, weird calculation heavily influenced by wide bid/offers on “lottery” ticket types of options).

I highly encourage you to read that particular T-Report, partly because it is contentious, but it also forms the crux of our argument that we had no panic, just some fear.

The working premise is:

Some de-risking occurred Monday, as stops were triggered, vol sellers got scared away, etc.
While de-risking occurred, there was no panic.
That by the end of the week, away from the yen carry trade, much of the de-risking had turned to re-risking.

On a scale of 1 to 10 on how at risk markets were going into last week, with 10 being the most risky, we were probably sitting at a 7 or 8. By Monday lunchtime, it had dropped to a 5 or so, as prices had dropped too quickly, and the move was too closely tied to a trade that once unwound, wouldn’t act like a catalyst again.

By Tuesday, we were back to a 6 or 7 as we saw clear evidence, not only of no panic, but also of investors re-risking. By Thursday’s close, we were back to an 8 on risk, as people piled into risk as the belief that the worst was behind us became consensus.

Why We Are As Bearish This Weekend as We Were Last Weekend

The bearish case boils down to this:

The narrative that there was panic is overblown. There was some fear, but it was nowhere near the level of panic, and if anything, we’ve pivoted back to complacency.
We learned very little about the economy last week, and we fully expect to see weak economic data once again hammering home recession fears (with a Fed that will be reluctant to act, due to what we believe are overblown inflation concerns).
We need to get through a few more important earnings calls, which no longer seem to create an almost obligatory bounce in the important stocks and major averages.
The 10-year Treasury yield is back to 3.94% (thankfully) and has the potential to rise more as the campaigns move on to discuss policies, and it was quite clear from the lack of demand at the Treasury auctions that the move to much lower yields had been technical.
Nothing about the geopolitical landscape has improved and many of the risks of escalation and expansion remain out there.

It is possible that no catalyst occurs to drive stocks lower, but we see plenty of potential catalysts, ready to spark another wave of selling. Positioning is once again too bullish and susceptible to a rapid pullback. Finally, liquidity is abysmal – in BOTH directions, which is dangerous and why we are comfortable not giving too much credence to Thursday’s rally.

Bottom Line

What a wild week, but little was resolved, and we are back to bearish stocks, a bit worried about credit, and largely comfortable with bond yields (though we’d like to see 10s back above 4.1%, but that is unlikely if we get the weak economic data that we are looking for).