Investors Borrowed Like Crazy During the Rally. Now They’re Paying the Price
Wall Street Journal
By Gregory Zuckerman, Jack Pitcher, Vicky Ge Huang and David Uberti
Updated Aug. 12, 2024 12:53 am ET
They built over months: big bets on the Japanese yen. Complex cryptocurrency wagers. Investments in hot tech companies.
Common to all the trades were heavy doses of leverage, or borrowed money, which investors used to amplify expected gains. As markets rose through the first half of 2024, the investments generated windfall profits, inspiring copycat traders to get on board and pushing prices higher.
Now the tide has turned. Unrest has returned to global markets over the past month, and investors are now in retreat from these once-unstoppable trades. While the market has calmed in recent days and the Dow industrials remain within 5% of their record high, traders caution that there is reason to brace for more upheaval.
What’s behind the tumult? Recent losses were caused in large part by a “deleveraging,” said Andy Constan, chief executive of Damped Spring Advisors, a consultant for macro hedge funds.
Changes in economic or financial conditions can force investors to sell one piece of their portfolios, such as U.S. or Japanese equity holdings, to deal with losses from another, such as leveraged bets on a weak yen. The messy process to reduce risk takes time before traders can reload.
“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 said.
July was one of the largest deleveraging episodes for hedge-fund clients of Goldman Sachs’s prime brokerage in the past 10 years, the bank said.
The summer doldrums
This deleveraging came at perhaps the worst time for markets—smack in the middle of summer months in which many traders and investors are vacationing. While more trading than ever is automated, decisions made by individuals still matter. Fewer pros in the office mean a shortage of seasoned individuals on trading desks, and fewer investors around to step in to buy as prices plunge.
It is a reason August has seen examples of panic in the past, such as the August 1998 collapse of the hedge fund Long-Term Capital Management and August 2007’s “quant quake.”
During the tumult of the past week, “The liquidity was worse or equal than during the Covid market crash,” said Patrick Heusser, head of crypto lending at Trident Digital.
It’s difficult to identify the exact causes of market tumbles, of course, and the accurate explanations are likely many. Evidence of a slowing U.S. economy certainly contributed to the volatility.
Still, much of the whiplash investors feel from a market that fell so quickly, and then snapped back abruptly, can be attributed to a rush by investors to pull back on leverage quickly, either on their own or after receiving calls from brokers.
Betting big on Japan
When highly leveraged bets turn the wrong way, sharp reversals can ensue. Brokers require more collateral to be posted against borrowed money, and hedge funds can become forced sellers to cut risk and meet those requirements.
How much leverage had investors piled up? In July, net bets against the yen by hedge funds and other speculators that usually rely on leverage reached their highest levels since 2017, according to the Commodity Futures Trading Commission. The net figures reflect short positions, betting on declines, minus long positions, anticipating gains.
Funds that make macroeconomic bets and others had been shorting the yen or otherwise taking advantage of near-zero benchmark interest rates in Japan to borrow the currency, sell it, and invest the proceeds elsewhere. Pros call it the yen carry trade.
Some swapped yen for dollars, for instance, to buy higher-yielding Treasury bills. At a July peak, hedge funds and other speculators’ short bets on the yen were worth a collective $14 billion, according to the CFTC.
Another sign of the building leverage: Japanese banks’ foreign lending reached $1 trillion in March, according to an ING analysis of Bank for International Settlements data, a 21% jump since 2021.
The trade unraveled over the past month as the gap between U.S. and Japanese government bond yields narrowed ahead of expected rate cuts in the U.S. It came under new pressure when the Bank of Japan raised interest rates, driving up the yen and forcing these traders to unwind their leveraged bets.
By Tuesday, the day after the recent market rout, those bets against the yen had plunged more than 80% from the peak, to a more modest net short position.
“There are leveraged investors blowing up because they borrowed immense amounts of low-yielding yen to buy everything else,” Steve Sosnick, chief strategist at Interactive Brokers, wrote to clients last week.
Tech turns into a wreck
Other popular leveraged trades have turned painful. For more than a year, hedge funds, computer-driven quantitative funds and others piled into big U.S. technology stocks by using borrowed money, often while betting against small-cap stocks, according to investors and analysts.
The trade flipped on its head in July, thanks to lackluster earnings that hurt tech shares and unleashed a long-awaited rally in small-cap shares, partly on the expectation that they would benefit from lower borrowing costs. Over the past month, longtime investor favorites such as Tesla, Amazon.com and Nvidia have dropped by 15% or more.
In the crypto market, the first five days of this month saw more than $3 billion of “forced liquidations,” or involuntary sales of positions by traders relying on borrowed money, after their margin accounts proved insufficient to handle recent losses, according to the data company CoinGlass. Bitcoin prices dropped over 18% during those five days, while Ethereum fell 24%.
Crypto investors spent much of the period since the collapse of the FTX exchange in late 2022 paring their leverage. That ended this year. The launch of U.S. exchange-traded funds holding bitcoin and Ethereum, the two largest cryptocurrencies, boosted investor optimism that major token prices would rise.
Many expressed a bullish view by buying bitcoin derivative products that investors say have “inherent leverage,” meaning that by putting a little money down investors can score big gains. These include options and so-called perpetual futures, futures contracts with no expiration date that allow traders to bet on the price of a token continuously with as much as 100 times leverage.
The dollar sum of outstanding bitcoin derivative contracts on centralized exchanges reached $37 billion at the start of August, tripling from a year earlier, according to CCData. The market mayhem on Aug. 5 pushed that total down to $28 billion.
Pros are bracing for more volatility. They are circling the August employment report, set for release on Sept. 6, on their calendars. A second straight disappointment could confirm the worst fears of economic skeptics, sparking a new round of deleveraging. A strong report could show that July’s report was a one-off slowdown, affected by hurricanes.
“I’m telling them not to panic,” said John Lynch, chief investment officer at Comerica Wealth Management, referring to clients.
By Gregory Zuckerman, Jack Pitcher, Vicky Ge Huang and David Uberti
Updated Aug. 12, 2024 12:53 am ET
They built over months: big bets on the Japanese yen. Complex cryptocurrency wagers. Investments in hot tech companies.
Common to all the trades were heavy doses of leverage, or borrowed money, which investors used to amplify expected gains. As markets rose through the first half of 2024, the investments generated windfall profits, inspiring copycat traders to get on board and pushing prices higher.
Now the tide has turned. Unrest has returned to global markets over the past month, and investors are now in retreat from these once-unstoppable trades. While the market has calmed in recent days and the Dow industrials remain within 5% of their record high, traders caution that there is reason to brace for more upheaval.
What’s behind the tumult? Recent losses were caused in large part by a “deleveraging,” said Andy Constan, chief executive of Damped Spring Advisors, a consultant for macro hedge funds.
Changes in economic or financial conditions can force investors to sell one piece of their portfolios, such as U.S. or Japanese equity holdings, to deal with losses from another, such as leveraged bets on a weak yen. The messy process to reduce risk takes time before traders can reload.
“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 said.
July was one of the largest deleveraging episodes for hedge-fund clients of Goldman Sachs’s prime brokerage in the past 10 years, the bank said.
The summer doldrums
This deleveraging came at perhaps the worst time for markets—smack in the middle of summer months in which many traders and investors are vacationing. While more trading than ever is automated, decisions made by individuals still matter. Fewer pros in the office mean a shortage of seasoned individuals on trading desks, and fewer investors around to step in to buy as prices plunge.
It is a reason August has seen examples of panic in the past, such as the August 1998 collapse of the hedge fund Long-Term Capital Management and August 2007’s “quant quake.”
During the tumult of the past week, “The liquidity was worse or equal than during the Covid market crash,” said Patrick Heusser, head of crypto lending at Trident Digital.
It’s difficult to identify the exact causes of market tumbles, of course, and the accurate explanations are likely many. Evidence of a slowing U.S. economy certainly contributed to the volatility.
Still, much of the whiplash investors feel from a market that fell so quickly, and then snapped back abruptly, can be attributed to a rush by investors to pull back on leverage quickly, either on their own or after receiving calls from brokers.
Betting big on Japan
When highly leveraged bets turn the wrong way, sharp reversals can ensue. Brokers require more collateral to be posted against borrowed money, and hedge funds can become forced sellers to cut risk and meet those requirements.
How much leverage had investors piled up? In July, net bets against the yen by hedge funds and other speculators that usually rely on leverage reached their highest levels since 2017, according to the Commodity Futures Trading Commission. The net figures reflect short positions, betting on declines, minus long positions, anticipating gains.
Funds that make macroeconomic bets and others had been shorting the yen or otherwise taking advantage of near-zero benchmark interest rates in Japan to borrow the currency, sell it, and invest the proceeds elsewhere. Pros call it the yen carry trade.
Some swapped yen for dollars, for instance, to buy higher-yielding Treasury bills. At a July peak, hedge funds and other speculators’ short bets on the yen were worth a collective $14 billion, according to the CFTC.
Another sign of the building leverage: Japanese banks’ foreign lending reached $1 trillion in March, according to an ING analysis of Bank for International Settlements data, a 21% jump since 2021.
The trade unraveled over the past month as the gap between U.S. and Japanese government bond yields narrowed ahead of expected rate cuts in the U.S. It came under new pressure when the Bank of Japan raised interest rates, driving up the yen and forcing these traders to unwind their leveraged bets.
By Tuesday, the day after the recent market rout, those bets against the yen had plunged more than 80% from the peak, to a more modest net short position.
“There are leveraged investors blowing up because they borrowed immense amounts of low-yielding yen to buy everything else,” Steve Sosnick, chief strategist at Interactive Brokers, wrote to clients last week.
Tech turns into a wreck
Other popular leveraged trades have turned painful. For more than a year, hedge funds, computer-driven quantitative funds and others piled into big U.S. technology stocks by using borrowed money, often while betting against small-cap stocks, according to investors and analysts.
The trade flipped on its head in July, thanks to lackluster earnings that hurt tech shares and unleashed a long-awaited rally in small-cap shares, partly on the expectation that they would benefit from lower borrowing costs. Over the past month, longtime investor favorites such as Tesla, Amazon.com and Nvidia have dropped by 15% or more.
In the crypto market, the first five days of this month saw more than $3 billion of “forced liquidations,” or involuntary sales of positions by traders relying on borrowed money, after their margin accounts proved insufficient to handle recent losses, according to the data company CoinGlass. Bitcoin prices dropped over 18% during those five days, while Ethereum fell 24%.
Crypto investors spent much of the period since the collapse of the FTX exchange in late 2022 paring their leverage. That ended this year. The launch of U.S. exchange-traded funds holding bitcoin and Ethereum, the two largest cryptocurrencies, boosted investor optimism that major token prices would rise.
Many expressed a bullish view by buying bitcoin derivative products that investors say have “inherent leverage,” meaning that by putting a little money down investors can score big gains. These include options and so-called perpetual futures, futures contracts with no expiration date that allow traders to bet on the price of a token continuously with as much as 100 times leverage.
The dollar sum of outstanding bitcoin derivative contracts on centralized exchanges reached $37 billion at the start of August, tripling from a year earlier, according to CCData. The market mayhem on Aug. 5 pushed that total down to $28 billion.
Pros are bracing for more volatility. They are circling the August employment report, set for release on Sept. 6, on their calendars. A second straight disappointment could confirm the worst fears of economic skeptics, sparking a new round of deleveraging. A strong report could show that July’s report was a one-off slowdown, affected by hurricanes.
“I’m telling them not to panic,” said John Lynch, chief investment officer at Comerica Wealth Management, referring to clients.
