Japanese Yen Crisis: The Dilemma of Intervention and the Impact of the USD/JPY Carry Trade
A spring must uncoil after being compressed,
The Yen has recently dropped through 155 per dollar for the first time since 1990, a significant event that has kept foreign exchange (FX) traders on high alert for potential intervention from monetary authorities. The yen's rapid fluctuations have led to speculation about potential intervention by Japanese authorities to prevent excessive weakening of the currency. The yen's decline is largely attributed to changing interest rate expectations.
Big Whoop, Why Does This Matter?
The Yen Carry Trade.
The carry trade refers to a financial strategy where an investor borrows money at a low-interest rate in one currency (in this case, JPY) and invests it in another currency with higher interest rates (in this case, USD). This strategy is profitable as long as the exchange rate between the two currencies remains stable. The current yen interest rate is set at ~0%, where the U.S. dollar 10y is currently at 4.6%.
The carry trade strategy is influenced by the yield differentials between the two countries. The yield differential refers to the difference in interest rates between two countries. If Japan’s interest rates are at 0% and US interest rates are at 5%, an investor can borrow in JPY at 0% interest, exchange it for USD, and invest in a US bank, earning 5% interest on their savings. Analysts from Deutsche Bank estimate this market to be around $20 trillion as of November 2023. This massive size means that the feedback loop exists more strongly for dollar/yen than any other currency.
The Risks of the Carry Trade
An Example
If the USD depreciates against the JPY, the investor could lose despite the interest rate difference. This risk is particularly relevant in the current economic climate, where there are indications that the Federal Reserve may start cutting rates. As well, many central banks are in the process of cutting rates as of now. If this happens, the USD could fall, and the JPY could appreciate, eroding the yield on yen carry trades.
The BoJ is stuck
Intervene in JPY Spot Market
If the BoJ decides to intervene in the JPY spot market by purchasing JPY, they would need to fund this by selling sections of their substantial US Treasuries hoard. As Japan sells US Treasuries (USTs) to acquire the dollars necessary to buy back their own currency, this action pushes bond prices down, causing US yields to rise. As these yields rise, the carry trade becomes increasingly profitable, which in turn puts more downward pressure on the yen. This results in a vicious cycle where interventions in dollar terms have to get larger, causing yields to rise even more.
Raise Rates
The BoJ decides to raise rates. There a couple issues with this scenario. Japan has one of the highest levels of government debt relative to GDP in the world. Higher interest rates would increase the cost of servicing this debt and Japan would have to cut spending or increase taxes, which could also hurt the economy. A rate increase would lead to an appreciation of the yen which would make Japanese exports more expensive on the global market, potentially hurting export-driven sectors of the economy. Given Japan's reliance on exports, this could be a significant concern. As well, this would lead to a great unwind of carry trade, more later. A sudden or significant increase in rates could also lead to market volatility, affecting stocks, bonds, and other financial instruments, putting Japans financial stability at risk.
Alternatively, the Fed could cut rates to reduce the appeal of the carry trade, leading to lower rate of devaluation, but this is unlikely given recent inflation readings and the fact that domestic monetary policy doesn't typically revolve around events in other countries.
The Unwinding
When a trade opens, say borrow JPY to buy USD assets, this devalues JPY. An increases the value of USD assets (due to demand to purchase the asset). This then creates a loop that continually brings new investors as the trade becomes more lucrative.
Now what happens if the trade goes south. In 2008, many of these trade were put into subprime mortgages. When these mortgages failed, there was a rush to the door to sell these mortgages, buy JPY and pay back the loan. This scenario reverse the feedback loop above. Where now the JPY is appreciating, creating a scenario where all other carry trades become less profitable or negative and then those trades unwind. The USD or counterparty assets then lose value as well.
The problem is the amount of leverage in this trade. The feedback loop creates an environment where more and more borrowing keeps fueling the trade, making it bigger and bigger. As stated by the $20 trillion market estimate stated earlier. When a catalyst sets off these trades to be unwound, it will snowball quickly. When $20trillion in assets get unwound and sold into the market quickly it leads to a scenario akin to the 1987 crash.
Thanks For Reading!
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