A long period of unusual calm in financial markets was shattered over the weekend, when the Japanese stock market imploded and cross-border carry trades unwound in a violent manner. Japan’s Nikkei stock index closed down 12.4 percent—marking its worst selloff since the “Black Monday” crash in 1987—and the yen is trading near the 142 threshold after having hit 161 less than two weeks ago.

Volatility expectations are soaring. Safe-haven Treasury yields are plummeting, with the policy-sensitive two-year returning less than 3.7 percent—down from 4.4 percent early last week—and the ten year seeing similar dynamics. Futures prices show the Nasdaq headed for its worst open in at least four years, and the VIX volatility index—Wall Street’s “fear gauge”—is trading with a 65 handle for the first time since the coronavirus pandemic hit in early 2020. Implied volatility in the currency markets is spiking upward as participants brace for more upheaval.

Observers are pinning the blame on Friday’s disappointing non-farm payrolls report, yet it isn’t clear what, precisely, acted as the proximate trigger.

The carry trade had undoubtedly grown too large. The trade—in which speculators borrow in low-yielding currencies and invest in high yielding alternatives—is notoriously difficult to quantify, given that it comprises millions of retail traders, thousands of businesses and hundreds of large institutions executing transactions in deeply-opaque over-the-counter foreign exchange markets. But the effects had become all too clear in the last few years, helping drive the yen well below fundamentally-justifiable levels, and push Mexican peso into clearly-overvalued territory, among others.

And equity markets were unquestionably overextended, in our view, with artificial intelligence companies and their technology-sector brethren trading at eye-watering valuations, helping boost US markets relative to their global counterparts. Positioning had grown too concentrated, within markets themselves, and across the global financial system, with too many investors crowded into too few US names.

We think more turbulence is likely in the coming days. The carry trade unwind should lose momentum as the ongoing short-squeeze plays itself out and the most dangerous exposures are covered, meaning that moves in the yen and peso—among others—could suffer violent reversals. Further downside in US equity markets seems plausible as probable as investors adopt a more realistic view on the fundamental outlook. And monetary policy expectations could shift dramatically in response to changing views on the Federal Reserve’s reaction function.

Investors currently expect the Federal Reserve to kick off its easing cycle with a 50 basis-point move in September, with a total of five and a half cuts priced into Fed Fund futures markets before year end. This would be an astonishingly aggressive transition, and seems hard to justify unless financial conditions tighten at a historically-unusual pace. Some second-guessing seems likely, especially given that the numbers embedded in Friday’s jobs reports didn’t make an airtight case for imminent recession.

The near-term implications for currency markets are complex.

Rate differentials are narrowing. With the US economy suddenly losing momentum, the euro, pound, loonie, Aussie, yen, and yuan should increase in relative attractiveness as monetary policy expectations converge.

But if market turmoil worsens, ‘dollar smile’ dynamics are likely to kick in. US Treasuries are still the world’s favoured safe-haven asset, and the greenback remains the currency in which the vast bulk of cross-border liabilities are denominated. Investors will retreat to the safest assets on the spectrum, and borrowers* will try to obtain dollar liquidity as quickly as possible. The greenback could spike higher.

And if the US sniffles, the rest of the world catches Covid. In every global business cycle in the modern era, a US downturn has impacted other economies at a lag, with Canada and Mexico tumbling in the initial wave, the UK and Japan following later, and the euro area and China coming last, with their labour market rigidities and state intervention efforts delaying the impact.

Bottom line: a relative period of calm in currency markets has come to an end, and we suspect many participants are unprepared, given that trading ranges had narrowed so much in recent years. For hedgers, trying to catch falling knives could prove dangerous at this juncture—some of the moves currently underway will eventually reverse themselves—but building up some tail risk protection, particularly via options strategies, could be a prudent approach.

*In practice, the vast majority of global financial institutions, businesses, and households are running explicit or implicit short-dollar positions that need to be closed out in the event of a rally in the greenback.

**I know I said I wouldn’t send any notes this week, but events necessitated doing so. My apologies : )