The 'carry trade' is unraveling, and economists worry that Fed rate cuts could exacerbate the situation.

• The global "carry trade" could be negatively impacted by rapid interest rate cuts from the Federal Reserve, according to TS Lombard economists.
• The warning emerges as market participants attempt to intensely reverse carry trades after a sudden worldwide decline in risky assets.
• Central bankers should exercise caution while the US economy is the top priority, according to economists at TS Lombard, as stated in a research note published Monday.

The global "carry trade" could be negatively impacted by rapid interest rate cuts from the Federal Reserve, according to TS Lombard economists.

The warning emerges as market participants attempt to intensely reverse carry trades after a sudden worldwide decline in risky assets.

In recent years, the strategy of borrowing in a currency with low interest rates, such as the Japanese yen, and reinvesting the proceeds in higher-yielding assets elsewhere, known as carry trades, has been extremely popular.

The weak U.S. economic data in August has contributed to the decline in stock prices, as investors fear that the Federal Reserve may not be able to lower interest rates quickly enough to prevent a recession.

According to TS Lombard economists, the Fed's natural response to soft labor market data and fresh recession risks would be to cut rates quickly. However, this would intensify the unwinding of any carry trade.

Central bankers should be cautious, but the US economy should be the top priority, they added.

'Triple whammy'

Freya Beamish, head of economists at an investment strategy research firm, stated that she hoped for a unified message from the Bank of Japan and Fed to calm market anxieties.

If the carry trade unwind is a problem, central banks should implement quantity measures to prevent Japanese and other investors from selling assets, allowing the Fed to cut rates without worsening financial instability, according to TS Lombard economists.

On Tuesday, a Federal Reserve representative refused to provide a comment when CNBC reached out for information.

On Monday, the yen and Swiss franc experienced a surge in demand, sparking speculation that investors were looking to quickly dispose of profitable carry trades in order to offset losses in other areas.

Recently, the Japanese currency has significantly strengthened against the U.S. dollar, reaching a high of 145.07 per dollar at 1:10 p.m. London time on Tuesday. This marks a significant shift from the period leading up to the July 4th U.S. holiday, when the yen dropped to 161.96 per dollar for the first time since December 1986.

HSBC strategists identified three major concerns that have emerged in recent days: the unwinding of carry trades, the monetization of artificial intelligence, and the possibility of an imminent U.S. recession.

HSBC strategists stated in a research note published Tuesday that while it may be premature to purchase, the fundamentals remain broadly supportive.

They stated that the greatest danger at present is a self-reinforcing sell-off, which could ultimately lead to a recession due to negative wealth effects and stricter credit standards.

'Reawakened with a vengeance'

The big carry unwind is currently taking place, according to Kit Juckes, chief foreign exchange strategist at Societe Generale.

Without breaking a few heads, it is impossible to unwind the largest carry trade the world has ever seen, according to Juckes, who made this statement on Monday.

Juckes noted that the largest foreign exchange market response was "position reduction," specifically long positions against the Japanese yen for the Australian dollar, British pound, Norwegian krone, and U.S. dollar were being removed.

He stated that a push below 140 a dollar for the Japanese yen in the near term would be unsustainable due to its impact on equities and inflation.

According to TS Lombard economists, global assets, including those in the U.S. and China, appear vulnerable.

The mismatch in maturity between the external balance sheet, which was built up over years of BoJ excess accommodation, led Japanese investors to exit foreign assets as the curve flattened during the early part of the pandemic.

"The Fed's decision to raise rates presented a new opportunity for the old carry trade to reawaken with a vengeance."

— CNBC's Michael Bloom contributed to this report.