The Bank of Japan (BOJ) was in a bind on Monday.
Its currency, the yen, was crashing while yields on their government bonds were surging. The solution — four days of unbridled bond buying by the BOJ to stem the hemorrhaging and contain interest rates. While the gambit worked (for now), Wall Street is waking up to this potential canary in the coal mine.
Big moves in the yen are rare, but traders pay attention when the currency starts moving. It’s the third most heavily-traded currency, and it’s involved in trillions of dollars worth of highly levered trades. Hedge funds try to arbitrage differences in interest rates around the world by borrowing in “cheap” currencies (like the yen) and investing in bonds in higher-yielding countries — the so-called carry trade.
For instance, if 10-year Australian bonds yield 5% while similar Japanese bonds are paying close to nothing, investors can sell the yen, buy the Australian dollar, and use the proceeds to buy Australian bonds. There are lots of moving parts and wonky details, but that’s the gist of it.
But because traders are essentially picking up dimes in front of a bulldozer, these bets are highly levered to maximize returns — which means they can fall apart quickly and cause systemic risk if enough traders are effected.
So when the yen starts making big upward or downward moves, traders face tough decisions. Hedge funds staring down the barrel of multiple margin calls will liquidate good bets — even safe haven assets like gold — to cover their bad bets. This is how contagion works.
For now, the BOJ’s bond buying — effectively printing more money, in this case yen — is supporting easy financial conditions. But if the bank’s hand is forced and it abandons the buying, a massive unwinding will likely follow. And no one is currently pricing in this risk.
Since the yen is being used as a cheap source of funds to leverage the carry trade, it’s a risky bet, points out Bloomberg’s John Authers. Everyone is piling on the same side of the trade such that it becomes self-fulfilling. But the yen has also historically functioned as a flight-to-safety haven during times of stress. If that relationship reasserts and the yen strengthens materially, it’s game over for those playing the carry.
“Far from offering sanctuary from the world’s strife, Japan is being treated once more as an ATM to fund risk-taking elsewhere,” Authers wrote.
While the yen and Japanese bond market have cooled for now, the BOJ will have a big decision to make. Further pressure could lead Japanese authorities to intervene in the yen. Japan has a long and storied history of weakening the yen to favor their exports. But this would be the first time since 1998 that the bank would intervene to strengthen the currency.
Surging commodity costs is currently the biggest factor. Japan is a huge energy importer, which depresses its currency as the yen is sold to buy oil and gas (and food and everything else) at higher prices. This outweighs the benefit of boosting their exports as their goods become cheaper abroad — especially as Japan has offshored a lot of its manufacturing over the last decade.
A plummeting yen also puts upward pressure on interest rates, which is at odds with the BOJ’s policy of controlling the entire yield curve. (By way of reference, the Federal Reserve only seeks to influence short-term U.S. rates.) If the BOJ is forced to abandon its yield curve control strategy, that brings the yen devaluation option to the forefront.
The other dynamic at play is the strengthening Chinese yuan, or renminbi, which is dangerously close to approaching the very level versus the yen that caused authorities in China to devalue its currency by 3% in 2015. That surprise move upended global risk markets and sent many stock markets around the world plunging into bear territory.
Today, add a pandemic and a war in Europe to the mix — not to mention a Federal Reserve that’s the most hawkish in at least two decades — and markets may not bounce back so quickly as they eventually did in early 2016.
Jens Nordvig, founder and CEO at Exante Data, recently remarked how different the current situation is from prior times of global gyrations in the currency markets, tweeting, “[Y]ou can only reach the conclusion that the regime is now totally different. This cycle is different, very different, and all asset classes are gradually waking up to this new reality, with [foreign exchange markets] showing it forcefully lately.”