The Bank of Japan unexpectedly raised interest rates, and for those who did expect it, the increase was larger than expected. And so “all hell broke loose”. But despite the fact that this left the stock market bears seemingly unscathed - even though they were wrong again for years - daring to come out from under their stones again to announce the end of the Yen carry trade, and thus the end of the world, the chances of them being right are again slim.
At the same time, investors would do well to store the date 5 August 2024 in their memory; the chances of seeing this more often should not be underestimated.
Not lifting
The Yen carry trade is a tried and tested recipe for fixed-income investors, especially those yearning for yield. Borrowing money in Japan costs next to nothing, while you can put that borrowed money to work nicely in an investment elsewhere that does yield. As long as yield spreads are large enough and volatility is limited, including of the currency being worked with, this is a “fine” strategy on paper.
But if the Bank of Japan does not stick to the “deal” and starts raising interest rates, moreover with bigger steps than before, while the rest of the world is rock-bottom heading for interest rate cuts, you have the puppets dancing. Quite apart from the fact that the interest rate differential, say between Japan and the United States, is narrowing, the uncertainty makes many investors think: ‘never mind that carry trade’.
The end?
What makes me laugh a bit are the headline hunters who almost immediately proclaim that this is the end of the carry trade and that stock markets must therefore go much lower still. Now I don’t rule out the latter, especially with rising tensions in the Middle East and the totally missed opportunity by the Federal Reserve, which should have simply cut interest rates to avoid ending up in a scenario where the market pushes the Fed with its back against the wall. “Oops!”
By the way, I would like to take this opportunity to ask all those gurus and pundits who until about two weeks back steadfastly insisted that the Fed was not going to cut rates and not infrequently ridiculed my expectation of three cuts, where they stand now.
Either way, rates may fall, but that the carry trade will just end is a wild assumption that often lacks substantiation. For one thing, the Bank of Japan has simply not managed to get inflation even close to 2 per cent in recent decades. Strange but true, the Bank of Japan has almost exactly the same definition of price stability as the Federal Reserve.
Little potential
The reason the Bank of Japan almost never, and thus certainly not structurally, gets to that 2 per cent inflation rate is because Japan is barely growing. Indeed, based on the latest estimates, potential GDP growth is heading into the minus within a decade. Japan is almost certainly going to shrink. A shrinking economy and 2 per cent inflation? Success. That potential growth, and the Bank of Japan’s policies that encourage it - it is not for nothing that the Bank of Japan reinvented yield curve control - underlie the survival of the carry trade.
Below is a chart showing the relationship between potential GDP growth and 10-year interest rates for the 20 largest economies (excluding India.) That relationship is overwhelmingly negative. The less growth potential, the lower the interest rate. Add, in Japan’s case, that ridiculous 2 per cent inflation target and you know what the Bank of Japan is going to do in the coming years as well. Interest rates must and will remain low. If you compare that to the growth potential of the United States, you understand that the interest rate differential will also remain gigantic forever. The core condition for the Yen carry trade is fully intact.
How then?
When the Nikkei Index closed 12 per cent lower, the biggest drop since 1987, the US economy was 100 per cent not in recession. Iran had not yet fired a missile - and let’s hope it stays that way - nor was there any talk of the AI bubble bursting or another Great Financial Crisis. Nevertheless, the VIX exploded to levels we had only seen before in 2008 and 2020.
How then? The answer is simple: leverage. With the ever-increasing lunacy of central banks, the size and scope of the carry trade has been ever increasing. Moreover, nobody has any idea how big that trade really is and where it ends. Let me put it this way: if the assumption is almost 100 per cent certain that interest rates in Japan are and will remain zero, there will surely be investors who have also bought some more exotic assets than just US government bonds with that borrowed money.
Volatility risk
So while it is obvious to me that the Yen carry trade is not over, but has temporarily unwound due to sudden uncertainty, I am not immediately happy about it. After all, it creates an even further accumulation of trades and thus more risk. After all, say 12 per cent off Japanese equities and a VIX of 65 don’t quite fit the current circumstances, do they?
Jeroen Blokland analyses eye-catching, topical charts on financial markets and macroeconomics in his newsletter The Market Routine. He is also a manager of the Blokland Smart Multi-Asset Fund.