Good morning! The title of the Smashing Pumpkins rock classic from 1995, Bullet With Butterfly Wings, could not have been more appropriate to describe recent market action. We had what seemed like a butterfly effect from a seemingly unconnected market, feel like a bullet in more distant markets. So why did policy decisions from the Bank of Japan have such large repercussions for far flung parts of the world as the Mexican Peso and U.S. technology stocks?
Keep Calm and Carry On
First, let’s introduce the idea of a carry trade. Carry is financial parlance for yield and is simply the income inherent in an asset or strategy. A carry trade is where an investor borrows funds in one currency to invest in another. Generally, this happens when an investor can earn a spread between the cost of capital (the borrowing rate) and the return on that capital (the lending rate). The larger the differential between the interest rates of countries, the greater the expected return for the investor.
However, currency markets are efficient, and they should price for this difference. The expected path between a pair of currencies should have a forward price that takes this rate differential into account. There isn’t a free lunch here!
The carry trade works quite well as long as:
- The interest rate differential remains wide
- The currency being borrowed in doesn’t appreciate more quickly than the additional carry being earned
In the vast majority of cases, the carry trade means borrowing from a more developed economy and lending to a less developed country, where you are paid higher interest rates due to a higher implied risk of being repaid and also to compensate for any currency fluctuations.
Turning Japanese
As we wrote in the “Turning Japanese” piece in May, many investors had resorted to borrowing Japanese Yen at extremely low interest rates, converting the proceeds to U.S Dollars and investing in higher yielding US Dollar assets. This had worked spectacularly well as not only had those investors earned a wide interest rate differential (5% annualized) but they also profited from the Yen weakening versus the U.S. Dollar (the Yen depreciated by 13% in the first 6 months of this year).
Billy Corgan’s shirt in the video for “Bullet with Butterfly Wings” hinted at the cost of borrowing in Japan:
When a carry trade like this works so well it brings two things: leverage and increased risk taking. It is safe to assume that many “smart” players borrowed money to add to these trades. Leverage makes the unwind more significant as it has the effect of too many people trying to squeeze through a door on the way out.
Carry traders may have increased risk by taking the U.S. Dollars and investing in riskier U.S. Dollar assets such as stocks or into currencies with a higher yield (such as the Mexican Peso). However, I’ve always been concerned by low volatility trends such as the Japanese Yen this year. The lower the volatility of the trend, the more risk betting alongside it. The unwinds are usually painful.
Unwind
What happened to cause some extreme moves across markets? The key lies in the expected interest rate differential between Japan and the U.S. In the same week we had both the Bank of Japan increase their policy interest rates and the U.S. Federal Reserve signal that rate cuts could be coming. Both were relatively small moves but the two changes in expectations had much broader implications. As currency traders worried about the narrowing of the interest rate differential, they began to buy Japanese Yen and sell U.S. Dollars. Add in the leverage that carry traders had been sitting on and its like adding a spark to a pile of kindling.
In just a few weeks, the Japanese Yen appreciated by 11% versus the U.S. Dollar and we saw large dips down in U.S. equities and other higher yielding currencies such as the Mexican Peso. Inevitably many carry traders were caught wrong footed and needed to react quickly, forced into selling assets in order to repurchase Yen.
Although the markets have once again found some calm, it feels like today’s markets are full of kindling and looking for sparks. August means summer vacation and thin market volumes. Moves can be pronounced and occur quickly.
