The Global ‘Carry Trade’ Is Unwinding. Here’s Why It’s a Brutal Force Crushing Stocks Worldwide.

Stocks plunged on Monday, and market pros say a lot of it has to do with the global unwind of the yen "carry trade."

The carry trade refers to investors borrowing money at near-zero interest rates in Japan, and then redeploying that cash into higher-yielding assets around the world, such as stocks and bonds.

"The selloff here is to a large extent attributable to the unwind of the so-called carry trade," Ed Yardeni told Yahoo Finance on Monday.

Typically, the cheap cash raised in Japan is redirected into higher-yielding US Treasurys, with investors collecting the difference between the interest rates set by the Bank of Japan and the Federal Reserve.

But in times of strong risk-on sentiment, like the long period of bullishness that's fueled the stock market since the rally began in November 2022, the yen carry trade has spilled over into other assets like stocks.

"They took that money in and invested it in assets around the world including the Magnificent 7, Mexican assets, Brazillian assets, and some of that didn't go that far, they went into the Japanese stock market," Yardeni said.

But after the Bank of Japan unexpectedly raised interest rates 15 basis points last week amid the prospect of rate cuts by the Federal Reserve, the yen has strengthened. That's sparked a wave of margin calls, leading to speculators unwinding their positions and selling stocks.

"I think the proof of that is that it's a global sell-off, which suggests a lot of money was raised in Japan at 0% interest rates and used to speculate in other parts of the world, so I think that's all coming unglued and I think it's a lot of margin calls and I think it's going to happen pretty quick and the unwind should be over by the end of the week," Yardeni explained.

The unwind in the yen carry trade will go down as the biggest ever, according to a Monday note from Societe Generale.

SocGen's chief global currency strategist Kit Juckes said that while he is treating Monday's plunge in stock prices with suspicion, as big moves on Monday tend to "happen in a vacuum," there is still room for downside in the stock market and economy.

The risk going forward for markets isn't what the Japanese yen does, but rather what US tech stocks do, according to Juckes.

"The rally was huge, the valuations were stretched and Warren Buffett's liking for cash is making headlines again. If that market keeps falling, it will affect the economy and the Fed," Juckes said.

Juckes added: "The labour market remains tight, the economy is still growing. That would change if equities fell too far/fast, and it would change if the August jobs report at the start of September was very weak."

Yardeni maintained his positive outlook on stocks despite the sharp rise in market volatility.

"It's too late to panic is sort of my attitude towards this sell-off," Yardeni said. "I think the economy is doing better, and I'm blaming the weather for a lot of the weakness in July's employment report… and I still don't think we're going to get a recession out of all of this."