Just over a couple months ago the Bank of Japan made a simple yet historic announcement: that they were prepared to begin raising their interest rates shortly, perhaps as early as next month. Now admittedly on the face of it such an announcement wouldn’t appear all that groundbreaking—Central Banks the world over change their rates all the time, albeit rarely with such forewarning. But in Japan’s case the decision marks a pivotal moment in our modern financial history.
Japan is the world’s second-largest economy, and Japanese short-term rates had been hovering near 0% for almost six years. These two factors—high liquidity in combination with miniscule borrowing costs—have formed the backbone for a modern economic miracle known as the yen carry trade. But now with Japan preparing for the prospect of raising rates, the miracle is beginning to unravel…and it’s already started wreaking havoc with global markets.
The yen carry trade is a pretty sweet deal by which speculators could borrow money from Japan at well under 1% interest and then turn around and use the funds to purchase bonds or assets elsewhere, pocketing the difference as profit. This ultra-easy money policy was intended to spur Japanese bank investment and bring Japan out of a depression, but that didn’t really happen. Instead the money was used to finance global speculation. And because this “free money” was being distributed in seemingly limitless amounts by a sound industrial nation with deep pockets and a stable currency and rate history, the deal proved too good to pass up for major investment houses, banks, mutual funds, insurance groups, pension funds and hedge funds the world over.
The actual numbers are unfathomable, but we know the BOJ was injecting some $300 billion a day into the system (Zhejiang Online, April 20th), which was about $250 billion over their own stated “required level” of current account deposits. This means the banks were continually hard-pressed to find other uses for 5 or 6 times the money they actually needed, and that excess liquidity went anywhere and everywhere there was a profit to be had. The yen carry trade has bolstered U.S. Treasuries certainly in recent years, but in a highly competitive financial world a few percentage points in risk-free profit is never enough. Thus these funds quickly began to feed more speculative bond, currency, derivative and stock markets. They’ve even provided significant hot-air to inflate the worldwide housing bubble.
But now (to mix metaphors) the gushing spigot is being shut-off as the BOJ ceases rolling over most of their short-term debt. All told, perhaps some $2.5 trillion will gradually have to be repatriated as the longer loans come due (International Forecaster, April 2006). The BOJ is under definite pressure to go slow and to keep the liquidity flowing as long as possible, but a recent Nikkei Financial Daily opinion piece stated the liquidity draining is actually happening quite a bit faster than expected, and hinted therefore that the first rate rise could come in June (Bloomberg, May 9th). This indicates the BOJ may be more anxious to tighten things up than market players would like.
In a world already buckling under financial strain and suffering from high crude oil prices, with rising interest rates in advanced economies, global current-account imbalances, and with the U.S. Dollar seemingly under attack by policies both within and without its borders, the end of the yen carry trade party is bound to bring an unpleasant hangover.
You may have seen a passing blurb in the American media last Monday, although you had to go out of your way to find it: equity markets all over the world opened the week in crash mode. India, Brazil, Argentina, Mexico, Indonesia, Singapore, Austria, Norway, Sweden, Belgium, Egypt, Italy, to name just a few…all were down anywhere from 3% to 8% on Monday alone. Strangely, if the situation received any attention at all in most papers it was described as being somehow tied to U.S. inflation concerns, although in the U.S. bond prices were barely moving. No real attention seemed to be given to the actual cause of this panic: these were all small-cap speculative markets that had been driven-up in recent years by money coming out of Japan and looking for someplace to go. As of this writing most of these markets have stabilized. Some have even rebounded. But recent history suggests the worst may be far from over because Monday’s action wasn’t by any means the beginning of financial troubles for the emerging and illiquid global markets.
The first warning shot was actually signaled more immediately back in March. Just a couple weeks after the BOJ’s initial announcement that they were putting the kibosh on the easy money trade, Iceland’s stock market plunged almost 20% in one day. While nominally triggered by a Fitch-rating downgrade of its credit-worthiness, the violence of the reaction was most certainly exacerbated by investor skittishness in anticipation of the unwinding of the carry trade. And a short chain-reaction ensued in other emerging economies, roiling markets in Poland, Hungary, Brazil and New Zealand…leading many commentators to draw comparison with the Asian Contagion currency crisis of 1997.
The effects are not limited to equities. As it stands now the Icelandic krona—already falling before the Fitch downgrade—has lost about 12% of its value against the dollar this year. The NZ Dollar as well has fallen about 15%, plunging almost 10% in the month of March alone. Combine these early aches and pains with Monday’s sneezes and it would seem this new Contagion is still in its early stages yet. Ultimately we should expect colds in foreign exchanges, bond markets, interest rates and derivatives markets everywhere. The Economist agreed back in December that “investors have good reason to fear the Bank of Japan”, especially in an era where consumers, governments and corporations are “leveraged to the gills”.
The unwinding of the yen carry trade doesn’t necessarily have to spell doomsday, but it is certain to suck the wind out of emerging markets and derivatives trading. And then again, our contemporary world is like a tired juggler with too many plates in the air—so any misstep at this juncture is bound to get very messy very quickly. It’s not the rate rise that threatens—certainly rates are heading up the world over, perhaps faster than those Japan would pursue—rather, it’s the loss of liquidity. And it’s unlikely the Fed will be able to pick-up the slack this time in the same way as it was able to paper-over the Asian Contagion of 1997 (and the collapse of mega-hedge-fund LTCM that followed in its wake). The Fed’s presses are already running white-hot, a fact which is finally starting to draw fearful alarms from the crowd. That means there is scant cushion available for any of the major players who might be adversely affected.
With the closing of the yen carry trade era an important support to the U.S. and global economies is being removed. And at this stage in history it’s anyone guess how far down the floor lies.
[UPDATE: No sooner do I get this analysis up than I learn the Bank of Japan is flooding the system with Yen in an effort to ward off a crash.
"The Bank of Japan pumped a record 1.5 trillion yen into the money market Monday in an effort to curb the sharp increase in unsecured overnight call rates, according to a report in the Tuesday edition of the Nikkei Financial Daily.The bank announced in the afternoon its planned funds-supplying operations from Tuesday onward, designed to calm the market. "It has recently lost some of its composure," the Nikkei quoted a BOJ official as saying."
So perhaps the crisis has been averted....for now, at any rate (hey, that's a pun!)]
