Don't sleep on the carry trade.

Because "the carry trade" is so abstract, and the kind of thing most people only hear about when it blows up, there is a temptation to dismiss it as Wall Street chatter--especially because markets have recovered since Monday's major selloff.

But it's not something to disregard. Things like "the carry trade," which is really just borrowing cheaply to buy momentum stocks, are the bread-and-butter of what professional players often do in financial markets. It's just another version of using leverage to amplify returns, much like the leverage you could also get by using options, or trading on margin, or whatnot. 

"Macro hedge funds have long utilized the currency carry trade--borrowing money in Japan, for example, and reinvesting in other countries where assets provide higher yields," wrote a Chicago Booth school explainer ten years ago. In the decade since, when Japanese yields went further negative, and "FANG" became the go-to long, that trade ballooned in size. This all traces back, by the way, to the Japanese stock bubble that collapsed in 1989, ushering in decades of deflation and ultra-low borrowing rates. 

J.P. Morgan thinks, after the market rout this past week, that 75% of those carry trades are now closed. Other traders I talk to aren't so sure. "I'd say we're in the third inning of this," one of them told me. Some desks estimate the carry trade has grown to $30 trillion in size. Deutsche puts it around $20 trillion. "When the Fed began to hike in 2022, the Japanese carry trade accelerated, pushing the Yen to its weakest level since 1986," Michael Cembalest of J.P. Morgan explains. 

The falling yen magnifies the carry trade return, because you not only borrow cheaply, but your Japanese loan gets cheaper as the currency weakens. Mark Cuban famously converted the loan he had used to buy the Dallas Mavericks into a yen loan. "I've been really happy with it," he told CNBC in 2013. 

So yes, it has been a widely used tool to borrow in cheap (and even depreciating) yen and buy better-performing assets. But why did this suddenly blow up? "Rising core inflation and [wages] finally prodded the Bank of Japan to raise rates, just as the Fed is projected to begin easing," Cembalest wrote. This all happened last Wednesday, when Japan brought rates into positive territory for the first time since 2008, while the Fed signaled a rate cut is coming. 

As a result, the yen appreciated sharply. Its 14% jump was one of the largest in decades. And that sent Japanese stocks to their worst three-day selloff in at least seventy years--a proxy for how other players using the carry trade might also have fared. "Note how it only took a BoJ hike of 25 basis points (!!) to trigger this" Cembalest wrote, "which is indicative of how large the unmeasurable Yen carry trade might actually be." 

The rub is that "consensus long" tech stocks are also stumbling as their cheap funding source has gotten more expensive. The Magnificent Seven index has dropped from 310 on July 10th, to 260 today--a 16% drop in the past month. Smaller momentum trades like Super Micro are down 18% just this week. 

Will savvy players jump in to buy these sold-off names on what largely amounts to as a positioning flush? Some will, certainly. But many others are waiting to see how much further the carry trade will unwind--and where that leaves long-term prospects for these once-high-flying names.