The conditions that contributed to the August 2024 market shock, including a crowded yen carry trade, stretched technology valuations, and elevated leverage, are beginning to reemerge. The rapid growth of leveraged ETFs has introduced a relatively new source of market risk that can mechanically amplify both rallies and selloffs. Investors should watch the jobs report, yen strength, and volatility measures for clues that deleveraging is beginning. On a recent walk along the waterfront near my home, I noticed a yacht in the marina with the name “Leverage,” a not-so-subtle reminder that many fortunes are built on borrowed money, labor and technology. It is not always a one-way ticket to success though. Investors use leverage to amplify returns but it also can increase losses. When too much leverage builds up in a particular market it has the potential to create volatile swings in prices if that leverage is quickly unwound. Furthermore, such an unwind in one market can reverberate into others, a butterfly effect that can stretch from Tokyo to New York. We saw such an unwind in early August of 2024. Similar signals seen the weeks before that event are popping up now, a sign markets are more vulnerable to a market dislocation than usual. On August 5, 2024, Japan’s Nikkei 225 index fell 12.4%, its worst single day drop since “Black Monday” in 1987 following the unwinding of leveraged positions and carry trades. This flash crash reverberated into U.S. markets, The Cboe Volatility index (VIX) , often used to measure market fear levels, spiked to over 65, levels not seen since the Covid-19 pandemic selloff. The S & P 500 index fell 3%, its worst day since September 2022. A carry trade is an investment strategy in which an investor borrows funds at a low interest rate in one currency, in this case yen, and uses the proceeds to invest in assets expected to generate a higher rate of return. These might be U.S. Treasuries or riskier assets like U.S. tech stocks or even cryptocurrencies. When one or both of these legs move against investors in rapid fashion, either a sharp appreciation in the yen or a selloff in the assets which have a higher expected return, they may be required to post more collateral against the trade or face liquidation. The Bank for International Settlements (BIS) analyzed the triggers that led to the unwinding, many of which are present in markets today. The long-term trend of a depreciating yen quickly reversed in July 2024 following a hawkish Bank of Japan interest rate hike and rumors of currency intervention. USD/JPY fell from highs near 161 to below 153 by the end of the month. JPY= ALL mountain USD/JPY Today the yen is trading near 40-year lows against the U.S. dollar, the Bank of Japan just hiked rates to 1%, the highest level since 1995, while Japanese Finance Minister Satsuki Katayama recent held an online meeting with U.S. Treasury Secretary Scott Bessent regarding possible currency intervention. The U.S. last intervened in currency markets in 2011 as part of a coordinated effort by the G7 countries following the Fukushima nuclear accident. While the U.S. may not be willing to intervene in a non-emergency situation, a sizable intervention by the Bank of Japan along with a communicated intention for further intervention with signaling from the Bank that it is willing to further raise interest rates could lead to a rapid appreciation of the yen. Additionally, the Commodity Futures Trading Commission’s (CFTC) weekly Commitments of Traders (COT) report released on Friday showed speculative traders are short over 146,000 yen futures contracts, the second most short they have been in any week since July 2024. Potential short covering is another avenue to rapid yen appreciation. Hidden leverage The BIS also referenced the valuations and strong price momentum of AI and technology stocks as a catalyst of the 2024 selloff. In 2026, the PHLX semiconductor index (SOX) is up over 80% compared to an approximate 8% increase in the broad S & P 500. The S & P 500 Technology sector is trading at almost 10x price-to-sales, a lofty multiple historically. These moves have been fueled in part by leverage, some of it apparent and some of it hidden. Retail traders are no longer only using margin to gain leverage but levered ETFs as well. The effects of these products on market fragility are not yet well understood. In a recent note, JPMorgan Asset Management’s Michael Cembalest explained the potential impact of these products on markets. “To deliver leveraged returns each day, the providers of such products buy into rallies and sell into declines, amplifying whatever price momentum is occurring,” he said. “The impact on global equity markets from leveraged semiconductor ETF rebalancing has grown by 5x since early 2024,” Cembalest remarked. In a separate note, JPMorgan Global Markets Strategist Nikolaos Panigirtzoglou said, “after reaching extreme levels earlier this year, there are currently signs of retreat in retail investors’ leverage in both options and margin accounts, presenting a potential headwind for tech stocks going forward.” Add to this margin debt that has ballooned 54% year-over-year through May, according to Bank of America Technical Strategist Paul Ciana, who wrote in a recent note that “though not yet at late-cycle extremes above +60%. Such extremes preceded SPX tops in 2000, 2007 and 2021. If the current margin debt trend persists, risk of a rapid expansion in volatility and sizable correction in risk assets becomes more probable.” Leverage is not just in the yen carry trade and tech stocks. A recent tweet from trader and philanthropist John Arnold notes the multiple layers of leverage currently in the cryptocurrency ecosystem: “Modern-day finance: You can get leverage via margin to buy a 2x leveraged ETF on MSTR, which is itself a leveraged bet on BTC, partly via a novel security whose cost of capital rises as its price falls, increasing leverage further as it declines. Works great in a bull market,” he said. These trades are all tied together and can snowball during an unwind. The BIS noted the around 20% losses in both Bitcoin and Ethereum during the 2024 unwind suggesting “that retail traders faced margin calls and may have been forced to close positions even in seemingly unrelated assets.” A rise in expected volatility can lead to further derisking as institutional funds tighten risk controls and exchanges tighten margin requirements. Sudden catalyst The catalyst for such an unwind can often be seemingly minor news. A weaker than expected monthly nonfarm payrolls report sparked the selloff in 2024 with the BIS noting, “This outsized market reaction to a single data release hints at a key role of amplifying factors, most notably deleveraging pressures amid thin markets (as is common in August). The vehemence of the move reflects in part the prolonged prior phase of risk-taking amid unusually low volatility.” Markets face an analogous situation this Thursday with the release of June’s unemployment report ahead of a three-day holiday weekend that could see thin liquidity as traders head out early to the beach and other vacation destinations. Financial markets are showing many of the same leverage-driven characteristics that preceded the August 2024 selloff, with elevated positioning across currencies, equities, and crypto raising the potential for a chain reaction of forced liquidations if sentiment turns. Investors should keep an eye on Thursday’s employment report as well as yen and VIX levels for clues to a potential unwind. THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
