In the wake of recent market turbulence, investors who had aggressively borrowed to amplify their trades are now grappling with significant losses, as a rapid deleveraging wave sweeps through global markets. While the Dow Jones Industrial Average remains within 5% of its record high, the calm is deceptive. Traders are bracing for further upheaval, as the unwinding of several high-risk, leverage-heavy trades continues to unsettle the financial landscape.
The market’s first half of 2024 was marked by a fervent rally, fueled by large-scale bets on the Japanese yen, complex cryptocurrency positions, and investments in high-flying tech companies. These trades, often amplified by borrowed money, yielded substantial profits, attracting a wave of copycat investors and pushing prices to new heights. However, as market conditions shifted, the very leverage that magnified gains has now turned against these investors, leading to a painful retreat.
Andy Constan, CEO of Damped Spring Advisors, a consultancy for macro hedge funds, explained that recent market losses are largely the result of deleveraging. “The deleveraging first has to get the people that are long and getting margin-called before it can be recycled into new longs, into new leverages,” Constan noted, highlighting the slow and messy process of risk reduction that has left traders vulnerable.
July 2024 marked one of the most significant deleveraging episodes for hedge-fund clients of Goldman Sachs’ prime brokerage in the past decade, according to the bank. This unwinding of leverage coincided with the summer months, traditionally a quieter period for markets as many traders and investors take vacations. The lack of experienced professionals on trading desks exacerbated the situation, as fewer investors were available to step in and stabilize falling prices.
Patrick Heusser, head of crypto lending at Trident Digital, likened the recent market liquidity to conditions seen during the COVID-19 crash, emphasizing the severity of the situation. While various factors contributed to the market’s volatility, including signs of a slowing U.S. economy, the sharp reversals experienced by investors can largely be attributed to the rush to unwind leveraged positions.
One of the most notable casualties of this deleveraging wave has been the “yen carry trade,” a popular strategy among macroeconomic funds and other investors. This trade involved borrowing yen at Japan’s near-zero interest rates and using the proceeds to invest in higher-yielding assets, such as U.S. Treasury bills. At its peak in July, hedge funds and speculators had amassed a collective $14 billion in short positions against the yen. However, as the gap between U.S. and Japanese government bond yields narrowed and the Bank of Japan raised interest rates, these trades unraveled, forcing investors to close their positions and driving the yen sharply higher.
By the day following the recent market rout, bets against the yen had plummeted by more than 80% from their peak, as investors scrambled to limit their losses. “There are leveraged investors blowing up because they borrowed immense amounts of low-yielding yen to buy everything else,” wrote Steve Sosnick, chief strategist at Interactive Brokers, in a note to clients.
The pain extended beyond currency markets. Leveraged bets on U.S. technology stocks, a favorite among hedge funds and quantitative investors, also turned sour. As earnings disappointed and small-cap stocks rallied, driven by expectations of lower borrowing costs, tech giants like Tesla, Amazon, and Nvidia saw their shares tumble by 15% or more over the past month.
In the cryptocurrency market, the first five days of August saw over $3 billion in “forced liquidations,” where traders relying on borrowed money were compelled to sell their positions due to insufficient margin accounts. Bitcoin and Ethereum, the two largest cryptocurrencies, suffered steep declines, with prices dropping by 18% and 24%, respectively.
The outlook remains uncertain, with many market professionals anticipating more volatility ahead. Investors are particularly focused on the upcoming U.S. employment report, set for release on September 6. A disappointing report could trigger another round of deleveraging, while a strong result might suggest that the recent slowdown was a temporary blip.
As John Lynch, Chief Investment Officer at Comerica Wealth Management, advised his clients, “I’m telling them not to panic.” However, with markets on edge and the effects of excessive leverage still rippling through the financial system, the coming weeks are likely to test even the most seasoned investors.
