Leveraging Lessons of the Yen Carry Trade

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on the latest in the equity and bond markets, economic trends, leveraging lessons of the yen carry trade, and opportunities in fixed income. We finished up with a wild-card round of questions and personal reflection.

Market Performance: Total Return

Let’s start with the markets. August started with a lot of volatility, but we ended in the green. What happened?

The S&P 500 Index was up 2.5% for the month and close to 20% for the year. The Russell 1000 Growth Index led again, up 2% in August and over 21% for the year. Growth did underperform the S&P 500 Equal Weight Index for the month, which is a sign of a broadening market. The Russell 2000 Value Index was down in August, despite the rally in the back half of the month. It’s up 9% for the year.

On the fixed-income side, the 10-year Treasury dropped, so you saw above-coupon returns for the Bloomberg US Aggregate Bond Index and invest-ment-grade corporate bonds. The standout in August was high-yield bonds, which rallied 1.6%. With rates dropping over the past few months, high-yield bonds are now up over 6% for the year. And finally, there’s the most consistent fixed-income performer for some time now: floating-rate loans, which were up almost 6% through August.

Magnificent 7

What about the Magnificent 7 performance?

August was a mixed bag. Four of the seven companies posted negative total returns, but their year-to-date performance is still strong, led by Nvidia, which is up 141%. That company alone has accounted for 23% of the S&P 500’s year-to-date returns. As we talked about earlier, market breadth has improved.

10-Year Treasury Yields Remain Range Bound

Yields fell across the entire U.S. Treasury curve in August. What changed?

Economic weakness and cooling inflation–that’s fueling the rally in rates. We broke inside of 4% during August. It’s something that hasn’t happened since February. I feel like the U.S. Treasury curve is trying to find a new range. With the current yield at 3.75%, It feels as though 3.5% is a lot closer than 4% at this point. Then there’s the recent jobs data, which has had an impact on the psyche of the markets. When you look at the jobs numbers for May, June and July, each month the numbers have been lower than last year. We’re seeing evidence of a weakening job market.

Economic Dashboard: GDP, Inflation, Jobs, and Consumer Spending

You mentioned the jobs number. Why do the monthly nonfarm payroll numbers keep getting revised downward from the original reports?

The first release includes only about 60% of the responses. The second release, which results in the revisions, includes about 25% additional responses. Pre-pandemic, the initial report would be drawn from ~70% respondents, and the revised numbers would include about 17% late responses. That’s why today’s updates today—with more sizeable downward revisions—have been more noticeable.

Nonfarm payroll revisions: Is the Labor Market Weaker than it Appears?

The Fed held its annual economic policy symposium in late August. What did you take away from Chair Jerome Powell’s speech?

I’ll sum it up: The time has come to lower interest rates. That’s what everyone took away, and I think it’s an elegant transition to rate cutting for the first time since 2020.

Do you think it's the right approach?

I do. For the past two years or so, the Fed has been right. And I think at this point not cutting rates enough would be a mistake.

What is the market expecting?

Currently, the market is expecting the Fed to cut in all three of the remaining meetings this year. In addition, the market is expecting 100 basis points in total, so that would mean in one of the meetings, the Fed would cut 50bps to meet market expectation. September is the most convenient one as the market is split on if the Fed will do 50, so the central bank could start strong if they elected. It is a toss-up right now.

Conditions Have Been Ripe for Using Japanese Yen as the Carry Trade Funding Currency

Equity and bond markets fell in early August, with many market commentators pointing to the Japanese yen carry trade as the culprit. To start things off, what is the yen carry trade?

Here’s a very basic explanation. The Japanese Treasury curve yields have been sitting at 1% and below. Investors have been borrowing in yen and paying a very low coupon. With that money, you can then purchase other instruments, such as U.S. Treasuries at, let’s say, 4%. In that scenario, you’d get a 300-basis-point coupon or spread with zero capital at risk. Now, there are variables that could upset this trade. The strength of the U.S. dollar and Japanese yen would have to remain the same for you to get a 3% return. But if the dollar loses 3% of its value, you’d be essentially flat on the trade. If the dollar increases, you’d get more than 3%. But the Japanese yen has not only had low yields, it’s been a weak currency for quite a few years. That has led to investors levering up and buying other assets with this trade.

The Carry Trade Has Been Popular Across both Emerging-Markets and Developed Currencies

Popular Carry Trades Performed Well Until Japan Raised Rates

So, what happened to rock the markets?

In late July, the Bank of Japan raised their target rate to 0.25%. While that doesn’t sound like very much, it’s the highest it’s been in over 15 years. And because of this you saw the yen appreciate 13% in a month, wiping out a swath of carry trade gains. This started an unwinding of the trade, resulting in risk assets selling off.   The Nikkei Index dropped over 12% almost overnight with worldwide ripple effects.

You had so much volatility that the Bank of Japan came back in a matter of days and said, “We’re not going to raise rates again.” What they were basically saying, “We need to protect asset prices.” After that, you saw a substantial drop in volatility and an asset recovery. To me, that’s pretty telling. We talk about central banks a lot, but this is a major indicator that we remain in a central bank world.

The Impact Was Quickly Felt by Japanese Equities

Here’s the million yen question. Do you think investors have found religion or do you think they’ll go back to this trade?

I’m reminded of one of my favorite quotes from J.P. Getty: “If you owe the bank a hundred bucks, that’s your problem. If you owe the bank a hundred million, that’s the bank’s problem.” So, for a small investor, the bank won’t do much. But because the markets—valued in the trillions of dollars—began to see an unwinding, the Bank of Japan stepped in and protected the asset owners. I think they understood what was at stake and wanted to keep the party going. In doing so, they’re essentially pushing inflation down to the consumer. As of today, the direction is in place. We’ll see how long they hold this position.

Fixed-Income Yields and Year-to-Date Returns

Now let’s talk bonds. Where do you see opportunities in fixed income today?

Let’s start with the Bloomberg US Aggregate Bond Index yields. Earlier this year, they were 4.5%. The year-to-date performance is very much tracking a coupon-like return. Now yields are inside of where they started, resulting in a slightly above coupon return. I think if they stay here or even go lower, we will have coupon-plus returns on the investment-grade side. On the leveraged finance side, bank loans and high yield are still returning around 6%.

I still like the opportunity in bank loans because of the yield differential. Loans are yielding over 10%. High yield is about 7.3%. Even if the Fed cuts 150 or 200 basis points over the next year, it would still be above the yield of high-yield corporate bonds. In my opinion, as long as the curve is inverted like it is—especially on the short end—or flat, I think bank loans still offer value. And again, if rates drop quickly, government bonds tend to do well, and corporate bonds tend to play catch up. Overall, the fixed-in-come universe has had a very solid 2024 thus far.

Let’s call this next section the wild card round. I’ll give you a topic, and you take it from there. First one: Assigned seats on Southwest Airlines.

I grew up with Southwest being the no-frills airline: No assigned seats, no charge for bags, no charge for change fees. With the changes at Southwest—including assigning seats—I view it as cutting into Southwest’s long-term goodwill. And to me, the new direction is due to activist investors for short-term gain.

Elon Musk’s hard political turn.

In my mind, he’s always been an independent, but he is aligning more now with the defiance of former President Trump. I think he very much identifies with that. And I think that’s why it may seem like he’s had a political turn, but to me Elon’s always been an independent.

San Francisco.

This one matters to me as a Californian. In late June, the U.S. Supreme Court ruled 6-3 that cities are allowed to enforce local ordinances against public camping and sleeping outdoors, which helps address the homeless problem. Up until now, the appellate courts had ruled cities could not enforce any anti-camping ordinance involving the homeless unless they could provide shelter for them. With the Supreme Court decision, I think authorities can make significant progress in solving the homeless issue that has negatively impacted so many cities—and I’d say especially San Francisco—in California and across the western United States.

Improvements the new Starbucks CEO, Brian Niccol, may make.

He is heavily into the data, so it wouldn’t surprise me if he started to reduce the options at Starbucks. For me, it’s really about pricing. The coffee options have gotten so expensive that I’ve personally reduced the number of times I visit Starbucks. I’d love to see them offer something basic and something reasonable. I’d love to see them charge $2 for a basic coffee. It doesn’t feel right paying $4 or $5 or $6 or $7 for a latte. It’s just too much. I hope he’s able to find enough efficiencies to reduce pricing, and I think he’ll start by simplifying.

Changes in real-estate commissions.

I think a natural reaction for real estate agents will be to try and keep the commission structure the way it was, even though now the seller no longer has to pay the commission for both their agent and the buyer’s agent. It’s a very meaningful change, and I’m interested in seeing how it all unfolds.

The stranded astronauts.

Some background here will help. In 2010, NASA launched a program called the Commercial Crew Program. It was designed to be the most cost-effec-tive way to get astronauts into space. Initially, Boeing was supposed to get the full award, but SpaceX came in and said, “We’d like a shot at this.” So, Boeing received a $4.2-billion contract, and SpaceX landed a $2.6-billion deal. Since 2020, SpaceX has launched 13 crewed flights—nine for NASA and four for commercial purposes. On the Boeing side, they have yet to complete a mission for NASA. The two astronauts are stuck in the Interna-tional Space Station because Boeing’s Starliner rocket ship has had so many issues that it’s deemed unsafe to ferry the astronauts back to Earth. So, SpaceX is coming to the rescue. This is just another major misstep by Boeing. Over the coming years, I’m sure we will hear about stories about the gross mismanagement of Boeing. To me, the stumbles by Boeing and success of SpaceX is the beauty of America. SpaceX—a new entrant—comes in, is given a shot, and has executed in spades.

Can you give us a personal reflection as we wrap up?

We just sent two kids off to college, and it’s caused me to reflect on my journey as a parent. It’s been a fulfilling and exhausting arc of sacrifice and love. From today’s vantage point, it’s hard to believe how quickly the years passed. There is an old saying, “the days can be long, but the years are short.” So, from someone who now has a son and daughter in college, my advice to parents is to make the days count.

Definitions

The 10-year Treasury yield is the interest rate the U.S. government pays to borrow money for a decade.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level.

The Bank of Japan (BOJ) is the Japanese central bank, which is responsible for issuing and handling currency and treasury securities, implementing monetary policy, maintaining the stability of the Japanese financial system, and providing settling and clearing services.

Basis points, otherwise known as bps or bips, are a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form.

The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, invest-ment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.

The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets.

Carry trades involve borrowing at low cost in one currency to achieve higher returns from investments in another currency.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

The effective yield is the return on a bond that has its interest payments (or coupons) reinvested at the same rate by the bondholder.

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. The nominal GDP growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

High-yield bonds are debt securities, also known as junk bonds, that are issued by corporations.

Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.

A Japanese Government Bond (JGB) is a bond issued by the government of Japan. The government pays interest on the bond until the maturity date.

Leverage refers to using debt (borrowed funds) to amplify returns from an investment or project.

The Nikkei is Japan's leading stock index comprised of the country's top 225 blue-chip stocks.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.

The Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected growth values.

The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

The S&P 500 Equal Weight Index is the equal-weight version of the widely used S&P 500 Index, which is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

A seasonally adjusted annual rate (SAAR) is a rate adjustment used in business to account for changes in data due to seasonal variations.

Spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, represented by treasury bonds. Spread income refers to the additional income from this difference.

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.

Yield is the income returned on an investment, such as the interest received from holding a security.

Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer defaulting.

‍

Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

Investors should consider a fund’s investment goal, risk, charges and expenses carefully before investing. The prospectus contains this and other information about the fund and can be obtained at www.AristotleFunds.com. It should be read carefully before investing.

Investing involves risk. Principal loss is possible.

A full list of holdings can be found at www.aristotlefunds.com and are subject to risk and to change at anytime. Any discussion of individual companies is not intended as a recommendation to buy, hold or sell securities issued by those companies.

Aristotle Funds and Foreside Financial Services, LLC are not affiliated with Pacific Life Fund Advisors LLC.

Foreside Financial Services, LLC, distributor.