If I loaned you $100 with the understanding you would only have to repay me $75, would you take that deal? What if I charged only 1/10th of 1% interest? What if I threw in an investment vehicle where you could put that $100 and be guaranteed by the government never to lose any money?
Meet the yen carry trade — the primary driver of higher equity prices since at least October 2011. We’ll take a look at how it works, and how it has distorted both equity and debt markets worldwide.
Basics of a Carry Trade
Generically speaking, a carry trade is an arbitrage that involves borrowing cheap and investing rich. In the old days, it usually meant borrowing at a low interest rate (e.g. yen) and investing at a higher interest rate (e.g. US dollars.)
One major risk, of course, was that the currency in which one invested would depreciate — resulting in a higher cost when the time came to repay the borrowing. Given how quickly currency markets move, it could turn a profitable trade into an unprofitable one in a heartbeat.
The Bank of Japan eliminated that risk when it repeatedly assured investors that the yen would continue to fall in value relative to the US dollar. A drop, for example, from 75 to 100 yen per dollar (expressed as an increase from 75 to 100 in USDJPY) represented a major opportunity for investors.
A $25 million return on a $100 million investment (25%) ain’t too shabby. It’s downright enormous when the initial investment is a loan collateralized by treasuries or other securities you already own. If the collateral impairment were 5%, for example, the annualized ROI would clock in at 400%.
If a 25% gain seems unlikely, consider that USDJPY rose over 60% between 2011 and 2014. In fact, it rose nearly 25% between Nov 2012 and May 2013 alone.
Most investors would be very satisfied with a 25% return, let alone a 400% return. But, that’s just the tip of the iceberg. Suppose that, instead of investing that $100 million in T-bills at a 10bps guaranteed return (plus the enormous currency benefit), an investor put that money into stocks.
I know what you’re thinking: “what about the risk? Stocks go up…but, they also go down!” Don’t worry. The world’s central bankers have got you covered. The Bank of Japan, for instance, puts nearly 5% of its $720 billion in annual quantitative easing into stocks. It’s not a steady stream — just when the “market” needs a boost.
Don’t take my word for it. According to those tin foil hat-wearers at the Wall Street Journal, 97% of the days the Bank of Japan “invested” money into stocks were days that the market either opened lower, or reversed to close lower after initially opening higher. The Plunge Protection Team at your service.
Last October, the government decided to up the ante, increasing the share of equities in its $1.2 trillion employee pension plan (the GPIF — the largest in the world) to 25% for Japanese stocks and 25% for international stocks. Note that this is money which retiring Japanese public employees might want to use some day to, you know, retire.
What effect has it had? Judge for yourself…
If the yen carry trade seems like a win-win, look at it from the standpoint of the Japanese. As a small, island nation that imports much of what it consumes, Japan is quite sensitive to changes in the price of imported items like raw materials, food and oil.
Ceteris paribus, a drop from 75 to 125 yen per dollar would increase the price of oil (traded in US dollars) by a whopping 66%. Knowing this, it’s not so hard to figure out why oil prices crashed beginning in August 2014 — at exactly the same time that USDJPY shot up through long-term resistance.But, that’s another story…
The fact is that continued depreciation of the yen will cost the Japanese people as well as those corporations which rely on imported goods. So, the next time the BOJ clobbers the yen, it does so with the knowledge that for every winner, there are many, many losers. There is no free lunch.
If that’s the case, why not just stop? The most recent data shows the BOJ owns almost ¥7 trillion in stocks. The ¥140 trillion Government Pension Investment Fund has allocated 50% of its assets to stocks. Let’s round it off and say the bank/government of Japan has a heavily-margined (note their tiny capital position below) position of ¥80 trillion ($666 billion) in equities.
First, note that this almost exactly the amount of annual easing that was announced in last October’s QQE expansion.
More importantly, it leaves Japan in a must-win situation. At its lows yesterday, August 24, the Nikkei 225 was off 9.5% from Friday’s close. It’s off a full 18% in less than 2 weeks.
If all of that $666 billion were in the Nikkei, the last two weeks’ exposure to equities would have cost them $120 billion — 2.4% of GDP!
Sure, some of it’s on the books of the pension plan, and the rest is presumably not going to be realized anytime soon. But, the data illustrate just how vulnerable Japan is since it: (1) put that much money into stocks; and, (2) is doing so in such a leveraged fashion.
At the end of the day, taking on this much risk smacks of desperation. With over 40% (and growing) of its borrowings going to pay interest on existing borrowings, and 250% of its GDP in debt, don’t expect things to change anytime soon. And, don’t expect the BOJ to sit idly by and allow the equity spiral to grow out of control.
They will increase QQE and/or devalue the yen again, and soon.