Next Potential Forex Unwind Risk Amid Election Volatility

• The foreign exchange market remains quiet despite global geopolitical and economic shifts.
• The yen carry trade unwind in August led to a temporary market pullback and recovery.
• Japanese pension fund may face challenges as the yen strengthens, impacting foreign investments.

The foreign exchange market has been eerily quiet since the yen carry trade unwind.

The realized volatility in most currency pairings is incredibly low. But if you look at the backdrop of what’s happening around the world, including geopolitical instability, interest-rate changes, and election uncertainty, FX should be going crazy at this stage, says David Barrett, the CEO of EBC Financial Group, a multi-asset broker.

The foreign exchange market has three major participants, and none of them is making big moves now, he noted. The first is on the surface layer, where short-term traders are betting on currency shifts and yields, which have taken over more volume than historically. On the second layer, you have more speculative traders, mostly made up of hedge funds and trading firms. And on the third layer, you have bigger money, where the pension funds and government allocators sit.

Short-term traders generally don’t affect market direction as steeply. They are in-and-out traders. Much of the moves from the yen carry unwinding witnessed in August happened at this layer, Barrett said. The hedge funds or larger market makers tend to respond to flows that are coming through, making them neutrally positioned based on those flows.

The last group, where the big money pension funds sit, trades foreign exchange for two main reasons: one, they allocate non-denominated currencies for their investments. Two, they hedge their currency exposure to remain neutral. They mainly readjust that hedge when currency rates move. And because we have not seen a huge amount of volatility in most pairs, they have been very quiet, he said.

But the yen could once again shake up an otherwise boring currency market and more.

In August, the US stock market saw a swift pullback (and recovery) after the Bank of Japan raised rates. Japan’s near-zero interest rates had made the yen a funding currency that was borrowed cheaply to invest in other assets where rates were higher — the so-called carry trade. When rates rose and the currency strengthened, the trade unwound.

But what we’ve seen in the yen carry trade is only the beginning, Barrett said. We have flushed out the short-term positions. However, any significant move in the dollar, such as weakness due to interest rate cuts against a strengthening yen, would unravel deeper positions where pension funds sit.

The big talking point in that trade is the Japanese pension fund, Barrett said. It has extensive exposure outside of Japan, and a strengthening yen is very problematic for it. Japan has the world’s largest government pension fund with $1.6 trillion…