By Brian Swint
The unwinding of the yen carry trade that was blamed for August's short-lived market turbulence might not be finished yet. That makes the Bank of Japan, not the Federal Reserve, the most important central bank meeting next week.
All eyes, of course, are on the Federal Reserve. Fed Chair Jerome Powell and company are widely expected to lower interest rates on Sept. 18. The usual rule of thumb is that cuts help stocks by making them relatively more attractive to bonds and making it easier for companies to borrow. But that might not be the case this time around, if the Bank of Japan surprises with another interest-rate increase at its next meeting on Sept. 20.
That's because the cut reduces the difference between the benchmark U.S. and Japanese rates, and interest rate differentials are one of the key factors that currencies respond to. The BOJ is widely expected to keep rates on hold after lifting its key rate from close to zero in July, but that's far from a certainty.
"Financial markets are definitely interested in how quickly the Bank of Japan hikes rates," said ING strategist Chris Turner. "It could certainly cause more volatility if there were unexpected tightening."
Higher interest rates in Japan make the yen carry trade--where you borrow money in the Japanese currency and invest it in higher-yielding assets elsewhere--less popular. While there's still a big difference between the 5% rate in the U.S. and Japan's 0.25%, the margin is getting smaller. And the strengthening of the yen against the dollar increases the pain because the traders have to pay back more in dollars than they borrowed.
"Most of the short-term carry trade, say 99%, has unwound," said Yusuke Miyairi, an economist at Nomura. "But there's still the medium and longer term carry trades that will take years to finish. It's now clearly less attractive."
Nomura sees the Fed cutting three times this year and four times next year, bringing the key rate to a 3.5% to 3.75% range. At the same time, it expects Japan to slowly raise its benchmark to 1% by the middle of next year. That roughly 2.5 percentage point gap is a lot smaller than at the start of the year.
For years, money borrowed for next to nothing in Japan was funding a lot of speculative bets. People weren't necessarily borrowing yen just to buy Nvidia and other Magnificent 7 stocks -- assets in places with higher interest rates, like Mexico, were a more popular destination. And in fact higher-yielding currencies such as the Mexican peso, Brazilian real, and South African rand fell the most as the yen appreciated last month.
But borrowing in Japan did provide liquidity for financial markets globally. Now that the bet is going the other way, some of that money is being drained from the system, in both direct and indirect ways.
"When forex volatility rises, it increases a metric called value-at-risk, " or VAR, measuring how much money could be lost in a trade, said ING's Turner. "Risk managers will then tell traders to downsize their portfolios," he said. "It's the volatility channel that can really trigger shrinking position sizes."
What's more, using borrowed money for trading magnifies both gains and losses. The risk is that, if things get worse for the carry trade -- if the yen appreciates more or the interest-rate gap narrows further than currently expected -- there's a chance traders will have to sell off more assets to pay back loans.
Nevertheless, ING's Turner said that the movements of the yen -- the most obvious sign of the carry trade reversing -- should become more orderly now.
When the Covid-19 pandemic hit in early 2021, the yen traded at around 105 to the dollar. Since then, the carry trade has become much more popular, pushing the currency's value down. By mid-July of this year, it traded at 160 to a dollar. It's since strengthened to about 142 -- a fall of more than 10% in the value of the dollar, a huge move for normally stable currencies. The Yen could go to 135 by the end of the year, ING predicts, a decline of almost 5% for the dollar from current levels.
"A lot of leverage had built up, and it burst starting in July," Turner said. "You're unlikely to see the same dislocation again."
But less violent swings could still mean bigger moves than investors are used to. At least as a source of liquidity and credit, the carry trade "could be a volatility factor that's not on everybody's radar because they think we went through this already," said Arnim Holzer, global macro strategist at Easterly EAB Risk Solutions. "Volatility will remain a little bit higher for longer, until the Fed is able to reach a number where rates actually stabilize. We think investors should have some exposure to products that benefit from volatility."
That's another way of saying that stock prices could move around -- a lot -- and that investors need to be prepared to stomach it. They might also consider an exchange-traded fund tied to the CBOE Volatility Index, or VIX, to take advantage of the moves. Examples include the iPath Series B S&P 500 VIX Short-Term Futures ETN and the ProShares Short VIX Short-Term Futures ETF.
Yes, the Fed and the BOJ will do their best not to surprise the markets as interest rates adjust over the next few months. But trying and succeeding are two different things. There could certainly be more bumps in the road.
Write to Brian Swint at brian.swint@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
September 16, 2024 01:30 ET (05:30 GMT)
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