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An obscure strategy wreaked short-lived havoc.
The global mini-crash on Monday, when stocks dived before largely recovering, can’t be pinned down to one cause alone. But one serious culprit was a long-standing foreign exchange strategy that suddenly turned into a disaster as Japan’s central bank and government tried to pull the yen out of an increasingly destructive nosedive.
The “yen carry trade” is a straightforward maneuver: borrow money in a country with low interest rates, such as Japan (or Switzerland), and invest in currencies with a higher interest rate, such as the U.S. dollar. If all goes well, the result is a cost-free source of profit. Not surprisingly, this has become very popular with financial traders, businesses, and even individuals who have used the technique to pay for mortgages in their home countries.
At current levels, an investor can borrow yen for around 0.5 percent and find a secure U.S. investment at around 5.5 percent. This means a 4 percent gain with no investment of your own. The only potential problem is if the exchange rate between the two countries starts to change. In this case, a stronger yen means that you will need more dollars to pay back the loan, potentially wiping out the gain and leaving expanding losses.
“These violent market moves will take place when participants in the ‘crowded trade,’ in this case yen carry, all try to get out of the pool at the same time. Moves on the downside can be swift and violent and at times can lead to changes in market psychology,” said Ichiro Sekimitsu, a former veteran trader in interest rate derivatives. “A necessary condition for the trade to continue is low volatility, so the predictability of the Bank of Japan and the Japanese Ministry of Finance, along with an underperformance of the Japanese economy, probably helped build the trade.”
All of this came unstuck on Monday as a fast-rising yen fed into a declining stock market, which in turn sparked a greater unwinding of what are known as “yen shorts”—bets that the yen will further decline. That sent the yen sharply higher in value as traders quickly closed out their positions. In mid-July, the dollar was worth more than 161 yen, but by the end of the Asian trading day on Monday, it stood at 142 yen, a 12 percent fall in value. That would easily wipe out a year’s worth of yen carry trade interest payments. Small wonder that there was an increasingly hectic race for the exits.
The catalyst was a tightening in monetary policy by the Bank of Japan (BOJ) just a week earlier, on July 31. The BOJ took markets by surprise with a double-barreled approach of raising the target interest rate on Japanese government bonds and announcing that it was sharply reducing the amount of bonds it buys as part of its efforts to control interest rates.
The changes appear small in comparison to the situation elsewhere. The new target rate for 10-year government bonds is still just 0.25 percent, up from zero to 0.10 percent previously and is miniscule when compared with the current 4 percent rate for U.S. Treasurys.
But the action bore a weighty meaning, breaking 10 years of an easy-money policy that had been meant to cause the very inflation that is now emerging as a problem.
BOJ Gov. Kazuo Ueda talked tough about the changes in July. “If the data shows economic conditions are on track, and if such data accumulates, we would of course take the next step,” he said, a clear signal to the markets that higher rates could be on the way.
The actions were taken as it became clear that a strikingly weak yen was pushing inflation higher and reducing the purchasing power of Japanese consumers. With the core consumer price index at 2.6 percent, it would seem far from a crisis.
But the impact on the average person has been palpable, with inflation outpacing earnings for 26 of the past 27 months. A country that had long sought inflation turned out to dislike it in practice, and increasingly worried government officials have been putting pressure on the central bank to do something. With Japan importing virtually all of its energy and most of its food, higher import costs bleed directly into the real economy and consumer spending.
Concerns over higher prices are described as a key factor in the low approval rating of around 25 percent for Prime Minister Fumio Kishida’s government. Kishida must run for reelection as head of the ruling Liberal Democratic Party in September, making the political woes of inflation even more palpable. If he loses, he will automatically need to step down as prime minister.
In its attempt to rein in the yen’s decline, Japan has already tried massive intervention in the foreign exchange market, spending a record 5.92 trillion yen (some $36.9 billion at the time) in yen buying on April 29, with smaller purchases on May 1, according to government figures.
But if the BOJ’s actions were strong, the impact on the Japanese stock market, which has been near all-time highs (it only took 34 years to get past the previous high), was equally strong. The Nikkei 225 stock index fell a stunning 12 percent, the second-largest percentage fall in history and a decline of 27 percent from its peak on July 11.
With signs of panic in the air, aided by a running chain of clickbait headlines about a market crash, the Tokyo decline fed into a perfect storm of negative news that included a weak U.S. jobs report and news that iconic investor Warren Buffett had unloaded a large part of his stake in corporate icon Apple. Never mind that the U.S. losses for the day turned out to be minor, despite the flash headlines, with the Dow Jones Industrial Average closing with a loss of 2.6 percent, hardly the market plunge the headlines would suggest. Positive news such as a relatively strong corporate earnings season was brushed under the rug, and gloom largely prevailed.
The fact that much of this was unwound within 24 hours is testament to the tenuous nature of the selloff. Tokyo traders decided they had been all wrong and proceeded to push up the Nikkei by 10.2 percent, the fourth-largest one-day gain on record.
By Wednesday, the Japanese market was up again, with the Nikkei rising 1.2 percent, and the yen had erased much of its gains. This came after BOJ Deputy Gov. Shinichi Uchida tried to put the genie back in the bottle, saying that the central bank will not raise rates further if there is market turmoil.
While his remarks were credited with calming the market for now, the band-aid cure is likely to have its own repercussions in the future. With his words seemingly contradicting from the vow by his boss a week earlier on raising rates if necessary, the remarks looked like a panic reaction or a signal that the BOJ is divided at the top. “That kind of communication undermines the credibility of the Bank of Japan. For the financial market, the uncertainty over the future of monetary policy has increased,” said Takahide Kiuchi, an executive economist at Nomura Research Institute. “Uchida said too much, and the BOJ now has a problem in its communication strategy.”
That credibility will likely become critical in the weeks ahead. Most analysts say the market shakeout is far from over, an analysis backed by data from the U.S. Commodity Futures Trading Commission that shows the total value of speculative yen shorts have decreased from $14.5 billion at beginning of July to $6 billion recently, suggesting there is more to be done if the yen starts strengthening again.
Kiuchi forecasts that the yen will revert to its “fair value” of around 115 yen to the dollar over the next three years. “The correction phase is still in the middle, depending on the U.S. economic situation. But it was only a crisis for Japan, not the global equity market,” he said. But for those in the yen carry trade, it means there is still a long way to go and likely more volatility to come.
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