How 2 Nerds Destroyed The World
Unwinding of the Yen Carry Trade and why it's NBD
Some people have asked for my thoughts on the unwinding of the yen carry trade. My understanding of this may have gotten a little rusty (as a value investor, I clearly spend more time on fundamentals than macro) — so please feel free to point out any mistakes in the comments section. We never really stop learning, do we?
Origins of the Yen carry trade
The origins of the JPY carry trade goes something like this. Following the 1989 crash, BOJ has been going on a veritable printing spree in order to stimulate their economy. This leaves households and corporations flush with excess cash, hence the immediate impulse is to invest in safe risk-free assets like JGBs.
However, JGBs have been yielding close to nothing for most of the past few decades, hence the next safest port of call for Japanese investors is to invest in hedged US Treasuries. While the yen carry trade typically implies borrowing to invest offshore, the borrowed money has to come from somewhere — this is its source.
It is also where the inverse correlation between USD:JPY comes from, and the main reason why JPY is considered a safe haven asset. Whenever the US economy hits a spot of trouble, Japanese investors flee by liquidating their US investments and repatriating the proceeds back to Japan. This repatriation is both substantial and predictable, making JPY a safe haven asset that is reliably inversely correlated to USD.
As one can imagine, most of the fleeing and repatriating happens in US Treasuries rather than in US equities — simply by virtue of the significantly larger market of the former. However, the impact might be felt more in the latter simply by virtue of its smaller size, since smaller flows hit harder in a smaller pond. That said, this is not the Armageddon some doomscrollers are prognosticating about, i.e. the wholesale destruction of US markets. US prices in the short-term, perhaps, but hardly their structural integrity over the long-term.
Stopping the Dominoes Falling
There is a supposed fear of a “doom-loop” involving a positive feedback loop between USD:JPY. Basically, what happens is that if too much repatriation of JPY occurs, it would act as economic stimulus and cause inflation in Japan, which might require further tightening by the BOJ. If you recall, tightening is what started this whole ordeal in the first place.
If at the same time the Fed has to cut rates owing to a recession, it would be encouraging even worse JPY repatriation. Such outflow of USD liquidity would surely have a negative impact on the US economy, which would require lowering interest rates further to provide economic stimulus. This ends up feeding the “doom-loop” flywheel, and could theoretically result in a non-stop self-reinforcing economic catastrophe.
However, Powell recently came out with a statement saying that they’re holding off on cutting rates until September. This puts a wedge in between the falling dominos of the aforementioned “doom-loop”, giving the BOJ at least a full month to rectify the issue. Given that most forex tragedies are caused by speculation rather than fundamentals, the solution is easy — “cause pain for the speculators”, as the BOJ has done in the past.
I’d imagine it would be very much in the BOJ’s self-interest to announce some kind of pain-inducing measure on speculators to halt the decline, e.g. by intervening directly in forex markets. For instance, they can simply print more JPY and sell them directly in forex markets in order to reduce the attractiveness of JPY — hence blunting the momentum of speculators. I know things aren’t that simple, but I’m also just thinking off the cuff about what they could potentially do, and this sounds like a viable strategy.
Also, I don’t see why the Fed must cut rates significantly now right now – they have room to wait until September. Last Friday’s scare about the Sahm Rule’s threshold being crossed is in fact 2 weeks old news — and the recently published lackluster jobs report is actually not that scary once you dig below the surface (mostly high-wage Tech job losses, not low-wage Manufacturing job losses). Services PMI also recently surprised to the upside, so I don’t see why Powell can’t give his buddy Ueda an extra month of breathing room.
In essence, I don’t really see this as some sort of uncontrollable situation. In fact, it seems like a scenario that both the Fed and BOJ should be amply prepared for within their respective 1,000,000-page risk management playbooks. I’m looking forward to seeing calmer markets by next month.
Well explained! Great job, Aaron!
I'm really pleased to see the Fed doing what they're doing. I don't think J-Pow gets enough credit.