We're taping a show on Wednesday, but I've had several messages asking for Josh Hendrickson's thoughts on today's economic developments globally. Here they are:
"It appears that most of this has been driven by Japanese monetary policy. Japanese interest rates have been low for a decade and a half. In fact, the Bank of Japan has kept its rate at or near 0% for the last 8 years.
"The central bank had been trying to keep interest rates low regardless of the duration (3-month, 1-year, 10-year). As a result, they had been buying government bonds to keep rates down. When they finally stopped, the currency started collapsing. By early July, the yen was the weakest it had been versus the dollar in almost 40 years.
"When this happened, Japan started using excess dollars to purchase yen and stabilize its value. Part of this was due to fears that the depreciating currency would start to pass through to prices and increase inflation. At the end of last week, the Bank of Japan increased interest rates by 0.25% and talked about the need to prevent inflation. That seems small, but they haven’t increased rates by that much since 2007. Also, the rhetoric on inflation made people think rates could continue to rise.
"Why does this matter? Given that the Bank of Japan was holding interest rates near zero, what people were doing was borrowing yen, turning that into dollars and investing those dollars in US markets. Earn a positive return on the money you borrowed essentially borrowed for free. However, this only works when the yen is stable or depreciating relative to the dollar and when interest rates are low.
"Japan’s support of the yen meant that it started to appreciate pretty rapidly. That makes these trades less profitable. Then you combine that with higher interest rates in Japan (higher borrowing costs), which makes that trade even less profitable. Then you combine that with fear of a US recession and that makes the trade even less profitable.
"Thus, there’s a massive scramble for yen to pay off these yen-denominated debts. How do you get yen? You sell dollars for yen, you sell yen-denominated assets (like stocks), you sell bitcoin for yen, you sell US stocks to close out these trades. Etc. etc. So the yen massively appreciates and the stock market collapses.
"For now, this looks like a Japan problem. However, the market volatility can create secondary effects on global markets. Also, to the extent to which large US banks were involved in this carry trade, they could take significant losses and cause problems in the US financial system. When you couple that with a weakening US economy and a possible escalation by Iran, this can potentially get pretty messy."
"It appears that most of this has been driven by Japanese monetary policy. Japanese interest rates have been low for a decade and a half. In fact, the Bank of Japan has kept its rate at or near 0% for the last 8 years.
"The central bank had been trying to keep interest rates low regardless of the duration (3-month, 1-year, 10-year). As a result, they had been buying government bonds to keep rates down. When they finally stopped, the currency started collapsing. By early July, the yen was the weakest it had been versus the dollar in almost 40 years.
"When this happened, Japan started using excess dollars to purchase yen and stabilize its value. Part of this was due to fears that the depreciating currency would start to pass through to prices and increase inflation. At the end of last week, the Bank of Japan increased interest rates by 0.25% and talked about the need to prevent inflation. That seems small, but they haven’t increased rates by that much since 2007. Also, the rhetoric on inflation made people think rates could continue to rise.
"Why does this matter? Given that the Bank of Japan was holding interest rates near zero, what people were doing was borrowing yen, turning that into dollars and investing those dollars in US markets. Earn a positive return on the money you borrowed essentially borrowed for free. However, this only works when the yen is stable or depreciating relative to the dollar and when interest rates are low.
"Japan’s support of the yen meant that it started to appreciate pretty rapidly. That makes these trades less profitable. Then you combine that with higher interest rates in Japan (higher borrowing costs), which makes that trade even less profitable. Then you combine that with fear of a US recession and that makes the trade even less profitable.
"Thus, there’s a massive scramble for yen to pay off these yen-denominated debts. How do you get yen? You sell dollars for yen, you sell yen-denominated assets (like stocks), you sell bitcoin for yen, you sell US stocks to close out these trades. Etc. etc. So the yen massively appreciates and the stock market collapses.
"For now, this looks like a Japan problem. However, the market volatility can create secondary effects on global markets. Also, to the extent to which large US banks were involved in this carry trade, they could take significant losses and cause problems in the US financial system. When you couple that with a weakening US economy and a possible escalation by Iran, this can potentially get pretty messy."
