One important factor behind the panic in the US stock market in early August was the unwinding of arbitrage trades, which has nothing to do with the slowdown of the US economy.

A month ago, the 12.4% drop in the Nikkei 225 index was partly attributed to investors eager to exit arbitrage trades, triggering a global stock market sell-off. On August 5, the Dow and S&P 500 indexes recorded their worst performance since September 13, 2022.

Investors are mainly concerned that much of the recent rebound in the US stock market has been driven by arbitrage trades. Arbitrage trading is a strategy based on borrowing at low interest rates to purchase higher-yielding currencies or assets. With the Bank of Japan maintaining ultra-low interest rates for many years, investors have bought stocks and assets in other countries using trades denominated in yen.

Recent data suggests that new arbitrage trades have become active again. Hedge funds with leverage have increased their short positions in yen futures.

Meanwhile, the yen has been appreciating, leading to speculation that there is room for the unwinding of arbitrage trades. The yen is typically used as a low-yielding currency to invest in higher-yielding alternatives. As of the time of writing on Friday, the USD/JPY exchange rate briefly exceeded 142.

The backdrop of the yen's strength is the expectation that the Bank of Japan will definitely raise interest rates again, which could have repercussions globally.

The volatility of the foreign exchange market is often driven to a large extent by differences in interest rates or interest rate policies around the world. As Japanese interest rates rise and the Federal Reserve is set to cut rates for the first time on September 18, the interest rate differential between the two countries will narrow further.

Steve Barrow, the Head of G10 Strategy at Standard Bank, wrote in a report on Thursday that closing arbitrage trades does pose a serious threat to the future optimistic view of risk assets. With the increase in Japanese interest rates and the appreciation of the yen, the funds that Japan has invested overseas through trade and current account surpluses for decades could potentially "revert".

Barrow added that the "most important central bank" could be the Bank of Japan, not the Federal Reserve, and the "slaughter" caused by the sharp rise in the yen and stock market crash in August could be a "harbinger of things to come". He wrote, "Although the Federal Reserve's moderate and stable interest rate cuts may be favorable for higher-risk assets, if the Bank of Japan's rate hikes lead to huge arbitrage trade closures, the Bank of Japan could make a mess of everything."

Tom Nakamura, Foreign Exchange Strategist and Co-Head of Fixed Income at AGF Investments in Toronto, pointed out that it is rare for forex trends to have a broader impact on the U.S. stock market and one has to go back to the Asian financial crisis in 1997 to find comparable occurrences. As of July 31, its parent company, AGF Management Ltd., managed approximately $36.5 billion (CAD 49.3 billion) in assets.

Nakamura said on Thursday that the 2022 UK sovereign debt crisis was triggered by a loss of government credibility in managing the budget, which caused the pound to plummet to historic lows and led to soaring yields in the region, but it was still to some extent controlled and not "so severe".

Nakamura said that the further closure of yen arbitrage trades is still a "very big cross-market risk", and investors are concerned about the actions the Bank of Japan may take in the next year or two.

Whether the next market volatility is caused by a slowdown in the U.S. economy or decisions by foreign central banks, "volatility remains high, in some cases even higher than what we saw in early August," the strategist said. "Some of this volatility comes from the closure of arbitrage trades, some from concerns leading up to the November 5th presidential election, and some from concerns about recent weakness in the economy, which may be more severe than anticipated."

Emons of Fed Watch Advisors described arbitrage trading as "Wall Street's oldest trade" and said it comes in "various forms and sizes". This may include borrowing in dollars instead of yen and betting on emerging markets or reflecting in trades between the Canadian dollar and the yen.

Emons said on Thursday that the "form and scale" of arbitrage trading will continue to evolve, noting an increase in short yen positions and a decrease in short positions in the Swiss franc, euro, and Canadian dollar. "The scale of yen arbitrage trading remains large, active, and seemingly increasing, despite the Bank of Japan hinting at the possibility of the next rate hike coming in October."

On Thursday, the US stock market closed mostly lower, with the Dow falling 219.22 points and the S&P 500 index declining for the third consecutive day. Signs of a slowdown in the labor market have dampened investor sentiment. However, lurking in the background is also concern about the appreciation of the yen.

AGF's Nakamura said, 'You are seeing how sensitive the market has become to yen carry trades.' Although further unwinding of trades could become a 'potentially big event,' he said his view is that carry trades 'in general remain an attractive strategy.' The market's recognition of the fact that risks exist helps mitigate the impact, with the worst-case scenario being unexpected.'

This strategist sees 140 as a key level to watch for the yen to dollar exchange rate. He added that gradual strengthening of the currency pair to the 130-135 range should be manageable. However, if this were to happen in the next one or two months, 'that could spell trouble.'