Remember how the reverse yen carry trade tanked U.S. stocks last summer? It's threatening again.

Stock prices have been whipsawed for three weeks now, with little relief in sight. The market's "fear gauge" - the Cboe Volatility Index, or VIX - is still well-above historical norms, suggesting that the market currently is controlled by volatility, not a firm trend.

Under normal conditions, uncertainty would send investors fleeing to safe-haven assets, but even those haven't been reliable. U.S. Treasury bonds have become a political negotiation tool in the Trump administration's trade war. As a consequence, many governments are selling Treasurys - and yields are rising, not falling.

Meanwhile, the U.S. dollar (DX00) continues to decline amid political and policy instability. Trump is now threatening Jerome Powell's position as chair of the U.S. Federal Reserve, adding another layer of unpredictability.

With financial markets in flux, gold (GC00) has emerged as the safe-haven asset of choice. Gold prices have soared so far this year, to a point where the yellow metal looks like an overcrowded trade.

Carry that weight

Stocks, bonds, the dollar and now gold are flashing varying degrees of warning. But investors' biggest risk is not a market but a trade - namely the "yen carry trade."

A reversal of that trade contributed to a 10% decline in U.S. stocks last summer. Markets are now facing similar conditions - only with more fuel on the fire. And just like last summer, investors aren't expecting trouble.

Here's what happened. The Bank of Japan (BOJ) surprised financial markets in July 2024 when it hiked interest rates for a second time, hinted at more rate hikes and announced a reduction in planned monthly Japanese government bond (JGB) purchases. It was one of the more hawkish signals Japan's central bank had sent in years.

The BOJ's action triggered a sharp rally in the yen. This pressured traders who had borrowed cheap yen when the U.S. dollar was strong, using that money to buy other assets (like U.S. tech stocks, given the timing). After the BOJ rate hike strengthened the yen, these traders were now upside-down in their positions. They were forced to close out - unwind - the yen carry trade and had to sell stocks to do so. That's how a yen-driven correction hit the S&P 500 SPX last summer.

Last year, the yen strengthened to 140 to the U.S. dollar before reversing and weakening. Now, the yen is hovering around that same 140 level.

Not only is the yen at 140 to the dollar a psychologically important barrier, it could trigger a wave of traders unwinding yen positions. Last year, traders may have been more resilient with their short-yen trades, given that U.S. stocks were generally in a steady uptrend. But this year there's no such tailwind. The S&P 500 SPX is well into correction territory and the general expectation is for U.S. growth to slow and inflation to rise. As the yen strengthens and risk assets decline, there may be little reason for short-yen traders to stay the course. This could further accelerate the downtrend in global stocks.

How gold could lose glitter

Here's the problem for gold. The dollar and Treasury yields are typically closely correlated. Declining Treasury yields weaken both the dollar and dollar-denominated assets. Now, the dollar is weak but Treasury yields are rising. This disconnect is highly concerning and raises not just the potential for further downside risk, but unpredictable tail risk.

Under these conditions, markets could follow a rocky path. The dollar would continue to decline, particularly against the yen, as political instability increases and the trade war intensifies. Adding recession fears and inflation risk, a further selloff in equities could be triggered. As a result, margin calls would increase and many investors would be forced to sell portfolio assets to post collateral.

At this point, the "disposition effect" takes hold. This is a behavioral finance concept that explains how investors usually sell winners and hold losers (due to loss aversion).

Look across the spectrum of financial asset returns so far in 2025. What is the market's big winner?

Gold.

Those margin calls would ignite a selloff in gold just when net-flow data and portfolio positioning surveys all indicate that investors are piling in.

Against this unstable market backdrop, the U.S. Federal Reserve could act to support economic growth and keep financial liquidity flowing. With the Fed's pace of quantitative tightening slowing, it's reasonable to think that the central bank might flip to quantitative easing if the U.S. bond market remains destabilized.

In this scenario, stocks and gold decline and U.S. Treasurys - particularly longer-term debt - stand alone as the safety valve for the markets.

Of course, that's only one potential outcome. But the markets are nervous nowadays. When fear takes over, traditional intermarket relationships tend to solidify. That's why Treasurys might be the better longer-term play; not gold.

Michael A. Gayed is a portfolio manager and publisher of The Lead-Lag Report.