The dynamics behind the February-March dive

From Feb. 27 to March 5, the dollar/yen tumbled from a peak of 120.75 to 115.16 (Figure 2). But, it is not just monetary policy and economic fundamentals that are driving action in the pair. The so-called popular carry trade, in which global money managers borrow yen in order to invest in higher-yielding and more risky assets, has created its own whirlwind of domino action, which directly affects yen values.

“The Chinese stock market dropped 9 percent overnight on Feb. 27,” Powell says. “Chinese stocks had been one leg of the carry trade. Fund managers had been selling yen to buy emerging market securities. The fall in Chinese equities sparked a squaring of those positions.”

The bottom line is that global investors became more risk averse in the wake of a string of global equity losses in late February-early March. Portfolio managers reduced their exposure to riskier assets amid the worldwide financial volatility, creating downward pressure on the dollar/yen as players cashed in their yen carry trade positions.

Powell pointed to data from the Commodity Futures Trading Commission’s Commitment of Traders (COT) report as evidence behind the “washout” in speculative yen positions during that time period. Powell notes that in the reporting period ending Feb. 20, speculative accounts were net short 102,600 yen contracts (including non-commercials and non-reportables). As of the March 13 COT data, the figure had slumped to 42,200 net short.

“Sixty percent of the market was cleared out,” Powell says. “It is a dangerous position when most of the market is leaning in one direction at the same time. That vulnerability is no longer there.”