The yen is in a unique position in global finance. At the same time, it can be both an indicator of market conditions and a fundamental cause of those same conditions. That’s because, for the last two decades, the yen has been, more often than not, the funding currency of choice for carry trades.
Recently, the Bank of Japan cut their key rate to less than zero. But it’s not about the Yen, explained Governor Kuroda; the policy, he said, was not targeting foreign exchange rates. Of course, that’s the sort of thing a central banker always says in polite company. A respected central banker wouldn’t/shouldn’t use their currency rate to gain a competitive advantage; it just isn’t what one does. Don’t you beggar thy neighbor, uh-uh!!
However, there is an important distinction to be made. It is fair to say that foreign exchange rates should reflect economic fundamentals; that’s reasonable. So if, for instance, a negative policy rate drives down rates throughout the curve, then it is also reasonable to expect the value of a currency to reflect those extremely low or negative rates, not to mention the economic fundamentals that inspired negative rates in the first place.
Therefore, Kuroda can rightly say… off the record…just you, me and the lamp post…plausible deniability…It’s all about the yen; it’s always about the yen!!
The Three Arrows of Abenomics
Shinzo Abe became the Prime Minister of Japan in December 2012 with the promise to end deflation and bring back growth. He would do this, he said, with the three “arrows” of Abenomics: fiscal policy, monetary policy and structural reforms. But part and parcel of the plan, the unsaid thing that would act as the enabler of Abe’s success was the yen; specifically a significant decline in the value of the yen.
In the weeks leading up to the election, as it became increasingly obvious that Abe would sweep into office, the yen started to depreciate. At that time, dollar/yen was just a few percent off the strongest level ever for the yen. By the time the votes were counted on December 16, 2012, the yen trend was set; eventually, its value fell by fifty percent versus the buck. Coincidentally, at the same time, the Nikkei stock index began to climb out of its hole; the index more than doubled over the next three years or so, riding on the coattails of the yen. (Chart: Yen is green, Nikkei is red)
But what have you done for me lately? The yen has not gone anywhere in about fourteen months. Dollar/yen is trading now at a level first seen back in November 2014; the peak was hit last June.
Interestingly, it was also last June when the Nikkei topped out; it is down about eighteen percent since then. Additionally, Japan’s GDP suggested recession last fall; fortunately an upward revision allowed the government to avoid that embarrassment. In any case, Abenomics looks to be stumbling, if not yet collapsing. What is one to do? Clearly, the answer is "weaken the yen."
On January 20, dollar/yen traded down to 115.97; the strongest yen reading in a year’s time. (The arrow on the chart indicates that day.) It’s an interesting level, as you can see on the chart below. On that day, BoJ boss Kuroda told Japan’s Parliament that there are plusses and minuses to negative rates; not to say the bank was considering them currently, but it doesn’t hurt to mention it. The following week the BoJ surprised some, if not most, by setting their key rate below zero for the first time ever. Furthermore, Kuroda emphasized they would go down further if need be. Dollar/yen rose sharply on the bank’s move, as planned. But the last few days has seen that entire move erased, plus some. Now what?
The yen matters outside Japan as well, but sometimes the extra attention is nothing but trouble. In the last couple of decades, the yen has often been the funding currency of choice. Because it is used in carry trades, the yen will at times strengthen at the most inconvenient times. That’s because, when push comes to shove and carry trades get liquidated, the yen must be bought in order to complete the trade. So at times of market stress, the yen often rallies, just when Japan most particularly wants it to fall.
Back in 1971, the Bretton Woods currency regime splintered. Currencies were no longer tethered to one another and anchored by stable values of gold and the dollar. From that point forward, currency values floated. Four decades ago, at the dawn of the new currency regime, there were 357 yen per buck. It is quite a bit stronger now. As I write, the dollar/yen is 117.25.
In September 1985, there was the Plaza Accord; a concerted intervention meant to weaken the dollar against the G5, soon to be G7, currencies. As you can see from chart above, it worked quite well against the yen, but it was just as effective in terms of the Deutsche Mark and British Pound, et al. Some might say it worked too well. There were attempts along the way to stop the dollar’s decline, first in early 1987, but, as is obvious from the chart, reversing the dollar’s trend was not so successful.
The ongoing strength of the yen became more and more problematic for Japan, especially in the years following the peak in the Nikkei, which topped out at the end of 1989. The index fell more than sixty percent in the next few years. In addition, Japan’s financial sector was under great stress in the early nineties. That’s because of nonperforming loans in construction and real estate. Banks were failing; the export powerhouse was sputtering; GDP was negative more often than it was positive, and deflation was beckoning. Interest rates were falling like a stone, but regardless, Japan was a mess. What is one to do? The yen must weaken!!!
Dollar/yen fell to 79.75 on April 19, 1995. Yet, the yen had never been stronger. Within a week, the G7 finance ministers met in Washington to discuss the general weakness of the dollar, in particular against the yen. The Fin Mins noted that recent movements in their currencies had “gone beyond the levels justified by underlying economic conditions in the major countries’. They called for an “orderly reversal”. Easier said than done, but combined intervention soon began to weaken the yen; dollar/yen was back over 100 by late summer, and the decline in the value of the yen looked set to continue.
Importantly, the determination to weaken the yen was duly noted by the market. The table was now set for the carry trade. The Bank of Japan had brought interest rates down to rock bottom by the second half of 1995 and there was no threat from inflation to turn the rates higher. The yen looked poised to weaken consistently. After a quarter century of gains; there was plenty of room to move. Low rates made it cheap to borrow yen and the currency’s ongoing decline was key because at the end of the day, the carry trader must buy back the funding currency, and no one wants to buy back their funding source at a higher price.
The End of the Yen's Initial Carry Trade
The first time I ever saw a mention of the carry trade was in the Wall Street Journal on February 28, 1996. The article, “Hedge Funds’ Complicated Bet Goes Bad”, recounted the end of what might have been the initial yen carry trade. “So much for all those swaggering hedge funds that thought they had found a way to make a killing off of Japan’s super low interest rates…The culprit is a seductive bet that seemed like a slam dunk to the financial professionals. And its untimely end helps explain the heavy selling that has been pounding the price of US Treasury bonds and the dollar, in recent days.
Here’s how it all began: Last year, the smart money bet heavily that a weak US economy would force the Federal Reserve to slash interest rates while the Bank of Japan was busy printing yen to refloat that economy. Presto: Bonds would rally, the dollar would go up, and the yen would weaken…As they happily collected the interest ‘spread’ from the big gap between Japanese and US interest rates in this so-called carry trade, the hedge funds sat back and waited to repay their yen-denominated loans with ever-cheaper yen.”
The reason for the WSJ story was that a sudden reversal coincided with the up-trends in the US bonds and dollar/yen forced the hand of well-known hedge fund operators such as George Soros and Tiger Management’s Julian Roberson. “The sharp reversal roiled the hedge fund world. As recently as mid-January, financier George Soros told a Tokyo investment seminar that the dollar would continue to rise against the yen for the next two years. He predicted that the Bank of Japan would probably keep interest rates low to help Japan’s beleaguered banking system. The financier also said that US Treasury debt remained an attractive investment.” Liquidating the carry trade was like operating a perpetual motion machine, “helping to create a self-fulfilling prophecy of weaker bond markets and a falling dollar,” explained the WSJ.
And so a perpetual motion machine is the image that I think works best to describe a hurriedly liquidated carry trade, particularly when it is done en masse. Selling out of a trade that is financed by the yen must be followed by, or simultaneously coincide with, buying of the yen in order to fully liquidate the transaction. But too much upward pressure on the value of the yen form those liquidations pushes others out of trades financed by that currency and so on and so forth.
Back in February 1996, the carry trade was very exotic, left only to the “sophisticated” market operators such as Soros and Robertson. And while the long bond/short yen trade from twenty years ago reported in the WSJ article caused significant losses for the hedge funds that were involved, the move in the bonds and dollar/yen do not look particularly dramatic in retrospect. Each market fell suddenly, but only four handles for the yen, about six or so for the bonds.
My point is that since the carry trade was not widely used in 1996, the rush for the exit was not as crowded as it would become a couple of years later, or for that matter how crowded it probably is today.
By 1998, or surely even sooner than that, the bond trade was again being financed by a short yen position. It is well reported that funds operated by Julian Robertson were once more in the “so-called carry trade”, but the crowd involved was much greater than before. No longer was the carry trade so obscure nor were the participants so select. Why not? The downtrend in the value of the yen was ongoing…120.00…130.00…140.00 to the buck and Japanese rates weren’t a problem.
The markets in the late summer and fall of 1998 were roiled by the events surrounding the implosion of the hedge fund Long Term Capital Management. Long story short, the US Bonds peaked on October 5 and then fell sharply; down more than eight points in the following four trading days. In tandem with the sudden reversal in the bonds, the dollar/yen was at 136.00 the day the bonds topped out, but fell as much as 25 handles in just three days; as low as 111.85 on October 8. “Massive deleveraging and in the process, the near-collapse of a major hedge fund added to price swings and further contributed to a drying up of liquidity in a wide range of markets and instruments,” said the Bank for International Settlements in a March 1999 recap of that period, International Banking and Financial Market Developments. “In particular, the unwinding of a large volume of carry trade positions may have been partly responsible for the largest daily gain displayed by the yen against the dollar since the abandonment of the fixed exchange-rate regime in 1971.”
The yen has weakened substantially since the advent of Abenomics in late 2012. It was a development that was clearly understood to be desired by the Japanese government. The Bank of Japan has kept interest rates quite low during this time; less than zero now. These are two key ingredients needed to make a carry trade work.
I think there are good reasons to believe that the carry trade has been widely used in the last few years. The chart below, with the dollar/yen in green and the SP 500 in red, suggests there is a tight relationship between the two markets. There are probably other examples as well.
Just because a trade is financed by the yen doesn’t make it a bad thing. I don’t know how things will play out. But, I think it is true that the yen, because of its unique position as a funding currency, is both an indicator of market conditions and a fundamental cause of those same conditions.
In one way or another it’s always about the yen, and it might be worthwhile to remember that in the weeks and months ahead.
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