Amazing how everyone is now an expert at the reverse carry trade, isn’t it?
I’ve been writing about this very scenario playing out since August of last year. That’s when I first raised the idea that Japan would become a source of financial stress. It happened, and it happened suddenly. Yesterday, the CBOE Volatility Index (VIX) touched 65. That super spike in the VIX was one of the largest jumps ever – the biggest one-day spike since 1990. The reverse carry trade took hold, triggering circuit breakers in Japan as forced selling took place around the world.
Yes, I was right (or so it seems) about this playing out. No, I don’t think it’s over. Why? Because while people are congratulating me on the “call” around the reverse carry trade, they are forgetting the other part of my prediction: I believe Japan is merely the spark to a credit event. The real risk is junk debt in the U.S. becoming severely mispriced.
Japan sparked the volatility spike, which is necessary for a repricing of default risk in corporate credit. This has been the disconnect all along. The problem isn’t so much with Japan, but rather with complacency in high yielding paper. Expectations are totally divorced from (1) an impending recession and (2) the message that small-cap stocks are sending. For over a year, small-caps have been trading in a way that should cause significant concerns around bankruptcy risk (the so-called zombie company dynamics).
If I’m right about the way this plays out, we are seeing the early stages of junk debt taking center stage. This would create some incredible opportunities as bonds suffer a credit dislocation, which is very different from what we’ve experienced the last three years in terms of duration.
I’m seeing people argue that this is a time to short. However, as I say repeatedly, shorting just doesn’t work over prolonged periods of time. In environments like these, the big down days tend to be followed by big up days – a phenomenon known as volatility clustering.
The whipsaw risk in these environments becomes very difficult to manage, which is why shorting tends to hurt more than it helps. If we are in a new phase in which volatility will on average remain elevated, then it’s best to consider more traditional long-only beneficiaries of risk, like utilities, treasuries and gold. Those have more room to run on a relative basis, at least until the credit event finally plays out.
Japan is the spark – the fire comes from within the house.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
