With a drop of more than 2% in the Japanese stock market at the beginning of today's trading, and a close to 1% drop at the end of trading, there is once again controversy over whether the Japanese yen arbitrage trade's "great clearance" has ended.

Then, what is the current status of the 'Great Clearing' of arbitrage trades?

An interesting news is that in the latest report, JPMorgan changed its focus and stated that three-quarters of the arbitrage trades have now been closed out.

Strategists at JPMorgan, Antonin Delair, Meera Chandan, and Kunj Padh, wrote in a report to clients. Since May, G10 currencies, emerging markets, and global carry baskets have been falling steadily, by about 10%, erasing this year's positive returns and significantly reducing returns since the end of 2022.

These strategists pointed out that the spot part of the global carry basket indicates that 75% of the arbitrage trades have been closed out, although this is not a completely reliable indicator.

They also said that while August's global central bank policy meetings are few, the window may be favorable for carry trade repricing, but the strategy is not attractive in the medium to long term due to the US election and prospects for declining US bond yields.

This statement is obviously further than the previous day's progress in Morgan Stanley's closure. At the time, Arindam Sandilya, joint head of global forex strategy at JPMorgan, said the 'yen carry trade closure' that triggered the stock market's recent sharp drop might not have ended yet. 'We believe that the closure of carry trades may only be 50-60% complete in the speculative investment community,' he said.

In fact, the size of the carry trades has long been a controversial topic among Wall Street investment banks. For example, we reported yesterday that Goldman Sachs is actually more optimistic than Morgan Stanley. In a latest report released by Goldman Sachs trader Anton Tran on Tuesday local time, he believes that the pressure from the closure of Japanese yen shorts has basically been eliminated, which means that the 'pain of arbitrage trades' will soon come to an end.

The reason for this series of market controversies, difficult to quantify from the source, is also because it is difficult to quantify the scale of arbitrage trades and how much money needs to be closed out.

Financing arbitrage trading refers to investors borrowing low-interest-rate currencies such as the Japanese yen and using the funds to invest in higher-interest-rate currencies or related assets in countries like the United States and Mexico. In recent years, due to Japan's super-low interest rates, the yen has always been the most popular financing currency. After years of western central banks actively raising interest rates to fight inflation, Japan said goodbye to the era of negative interest rates in April of this year.

The specific size of the arbitrage trading is difficult to guess.

However, the size of arbitrage trades is actually difficult to trace, as currency trading is not as trackable as stock market trading. Moreover, almost all cross-asset market participants, from hedge funds, family wealth management rooms, private capital to Japanese companies, will use this type of trading.

Of course, there are also some methods available on the market to evaluate its popularity.

One method is to look at the hold contracts tracked by the US Commodity Futures Trading Commission (CFTC). CFTC data showed that as of early July, hedge funds and other speculative investors held more than 0.18 million positions betting on the weakening of the yen, worth more than $14 billion. By last week, such positions had fallen to about $6 billion.

Of course, as ING's global market director, Chris Turner, has recently pointed out, CFTC-tracked forex position data is only the tip of the iceberg for Japanese yen financing and arbitrage trading. In recent years, banks, asset management companies and other institutions have also borrowed yen on a large scale, and even the Japanese government is in a sense a player in yen financing and arbitrage trading, so the position data can only look at changes in popularity at best.

In fact, the exact number is likely to reach the level of trillions or tens of trillions. According to data from the Bank for International Settlements (BIS) as of March, Japan's banking industry lent out approximately the equivalent of 1 trillion US dollars in yen to foreign borrowers, an increase of 21% over 2021. Much of the growth in cross-border yen lending has been in the interbank market, as well as loans to non-bank financial institutions such as asset management companies.

As for Japanese investors, as of the first quarter, Japan's net international investment was 487 trillion yen, approximately 3.4 trillion US dollars, an increase of 17% compared to three years ago. However, much of this comes from foreign exchange reserves, and traditional asset management companies' investment portfolio arbitrage trading is not the largest.

Finally, there is a market view that the scale of yen carry trades has reached 20 trillion US dollars. But in fact, this number is somewhat exaggerated and measures the total value of the Japanese government's assets and liabilities sheet, which is about 500% of GDP or 20 trillion US dollars. Although the Japanese government is indeed the largest yen carry trader in the market in actual terms, including this number is somewhat exaggerated...

UBS Group's global strategist James Malcolm estimated this week that the scale of yen carry trades established since 2011 is about $500 billion, of which about half has grown in the past two to three years. He believes that in the past few weeks, investors have closed out positions of about $200 billion, which accounts for about three-quarters of the positions he ultimately expects to be closed out.

Finally, regardless of the actual size of the yen carry trades in the market and how many have been closed out, a preliminary signal now is that, as the Bank of Japan yesterday promised not to raise interest rates rashly in the future when the market is unstable, the shock wave of the initial clearing of this wave of carry trades may have gradually subsided. Even if there are some clearing actions that have not been completed, they may unfold in a more gentle way.

In fact, although the three major US stock indices fell across the board again overnight, their correlation with the yen exchange rate is no longer significant. The well-known financial blog website Zerohedge has pointed out that the two are decoupling. Although US stocks fell yesterday, the rebound of the yen after a sharp drop during the Asian session was not significant.

Editor/Lambor