Why are financial markets collapsing and what is the Japanese “Carry Trade”?

The Japanese stock market isn’t doing too well. Everybody knows that the entire world has been facing high inflation, except for Japan. Japan has effectively stagnated since the 1990s, the beginning of the end of “Endaka” (Strong Yen) and Japan has faced issues of too much deflation. This meant that while Japan was actually lowering rates and had negative interest rates, everyone else was raising rates.

Now, this does something very interesting because when interest rates go up in, let's say, the United States, it becomes more attractive to buy the 10-year treasury bond over there. So, for example, if the 10-year treasury is trading for 3.76%, just like it is now, and the Japanese 10-year is trading for 0.82%, which bond would you rather have? The 10-year debt paying you 3.7% guaranteed and backed by credit of the U.S.? Or the Japanese 10-year paying you just 0.82%? It's a no-brainer - and if you have any other currency, you're going to sell that other currency and buy US dollars to invest in the US market. This creates a lot of selling pressure on currencies like the Japanese yen.

If you look at the VIX (also called the Fear and Volatility Index that investors buy when they are hedging their investments), the highest peaks/pivots of the VIX were just before the 2008 financial crash, before the COVID crash in 2020, and then this week. Those were the three biggest breakouts of the VIX over the last 20 years and actually the biggest in history as well.

So, what exactly happened yesterday that put us in the same category that we've been in only three times in modern history? It can be broken down into 3 categories:

1.??????? The Japanese market contagion

2.??????? The war escalation in the Middle East

3.??????? The economic crisis that's already unfolding in the US

Japan's market suffered its biggest fall since 1987 this week. But what caused this crash is also what caused the US meltdown – the “Carry Trade”. The Japanese Carry Trade has been an extremely popular investment strategy where people borrow money at low interest rates and then invest it elsewhere, namely in the United States, where interest rates are much higher.

Whether you're investing in just bonds at five to six percent or you're investing in the stock market, which has returned dozens of percentage points over the last couple of years, this has been a very profitable strategy as it exploits the low cost of borrowing in Japan and takes advantage of the higher returns elsewhere. Because the rest of the world has much higher interest rates on just fixed rates this is actually a great strategy. It's all fine until Japan starts raising their interest rates and protecting their currency, the Yen, which is what's happening right now. Japan is now raising its rate above zero for the first time in 17 years.

HOkay, now you're going to have to roll with me on this one because it's a little complicated, but I'm going to make it as simple as possible. Okay, here's an example of what a carry trade looks like. Let's say, you want to take on a margin loan on stocks in the US. It might cost you 6.5% in the US, but what if you could go to Japan and borrow at 1.5%? Well, that's a lot more desirable but is essentially an arbitrage of interest rates.

Now, how does this go wrong? First of all, to understand how it goes wrong, let's understand how it goes right. Let's say I borrow $1000 worth of Japanese Yen and I am going to use it to buy US assets. If the Japanese Yen keeps going down in value, it's actually going to be a lot cheaper for me to pay off that money. Every single year, I'm getting my 3% or 5% yield on money markets or treasuries. Let's say, after a year, I got $1,050 and the Japanese Yen fell 20% in value. So, I actually only have to pay back $800 worth of Yen: I picked up $50 very cheaply in the US, so I'm plus $50 over there and I can now pay that Yen back with $200 less. That’s a profit of 25% and since the Yen has been going down in value since the 1990s (deflation and stagnation), this seems like a risk-free investment.

So, what's wrong with this? Let's say you decided to take your thousand dollars over in Japan and you're going to borrow thousand dollars’ worth of Japanese Yen and you are going to invest that in US assets. Furthermore, Japan has been buying assets on 50% margin (you can buy $2,000 of US stocks with a $1,000 of a deposit). That is a typical margin loan in the US. So, now I borrowed the money cheap in Japan. The money that I borrowed very cheaply in Japan, I am now going to leverage again in the US stock market. This is not a problem as long as the Japanese Yen keeps devaluing.

However, the Bank of Japan decided to raise interest rates by 25 basis points last week as a direct response to increasing inflation. As a result, Japanese bonds have become more desirable, especially since Japan’s interest rates are now going up while everybody else is cutting. So, you're getting more of a yield in Japan. What happens when yields go down is that Japan is going to have to pay more (aka the $US depreciates against the Japanese Yen).

Over the last 30 days, the Japanese Yen has appreciated 10%. As a direct result, the borrowed $1,000 worth of Yen in the US now need to be repaid with $1,100 in Japan. This in itself is not a massive problem but is accelerated if the value of your investment is depreciating (for example when US economic forecast anticipates a recession or surprise data indicate an imminent, hard landing). ?Let's assume your investment in that “AI bubble” is now down by 35% and which equates to an unrealised loss of $700 on your $2,000 investment.

All of a sudden, you have $1,300 left over in the US but you also borrowed in Japan. So, you actually only have $300 of equity out of the $2,000 of stock you bought which is 15%. Now you get liquidated through margin call which in turn contributes to more selling pressure in the US. You are left with $300 to pay your $1,100 loan off in Japan. You will now also get margin called in Japan because you have $300 of collateral, left on the $1,100 loan you just took out.

Now you have to either borrow more from somewhere else to pay off that $1,100 loan or you're defaulting and you're destroying the banks, which now makes sense why banks start collapsing in Japan (soon). Some economists think the exposure to those margin calls could be as much as 10% of the United States stock market ($10 trillion of leverage in all risk assets).

So, what’s next? Well, maybe Japan can just print more money, right? Quantitative Easing (QE, aka printing money) is inflationary and Japan's debt to GDP already sits around 263% and any further QE would be counterproductive to what Japan is trying to achieve with bringing inflation down. Japan’s debt to GDP ratio is higher than Venezuela and it takes the number one spot for being the most indebted country in the world. Add to this that people are pricing in recession fears in the US and you've got a lot of uncertainty.

Yesterday, it all finally exploded. You had the Nasdaq down six percent at some point, the seven most valuable US tech companies lost a combined $1 trillion in market value. The overall market lost several trillion dollars on Monday. You had major brokers crashing all morning. Charles Schwab, Fidelity, Vanguard, TD Ameritrade, E-Trade, and Interactive Brokers all reported huge outages of their trading platforms, Bitcoin went down some 15 percent or more at points.

So, investors and massive institutional players who use this strategy are now being margin called and have to liquidate back into the Yen. But the Yen is strengthening so fast that they are losing money on the conversion at the same time that global equities are crashing, causing even more margin calls to occur. This is a problem because there's going to be a massive unwinding of all this Japanese carry trade capital. You saw just the beginning and the panic associated with a rapid unwinding this week. But what you don't see is all the other capital that is still wound up in this type of trade. It appears that there's a lot more here than meets the eye and as the Japanese Yen continues trending upward, any US dollars converted back into Yen are going to have eroded value, which makes the whole process even worse and makes margin calls that much more painful.

So, what exactly is the extent of the damage here? Well, if you look at the level of cross-border bank lending in yen, you have around a combined 250 trillion Yen in interbank loans in loans to non-bank financial institutions in cross-border lending. 250 trillion Yen (about $1.74 trillion or ￡1.36 trillion). That's a lot of money, and it's really just the tip of the iceberg. Remember every single dollar that needs to be recalled and sent back to Yen that gets ripped from the market is going to have a multiplying effect across the financial system. Those investors that get margin calls are going to have the immediate liquidity to fulfill the calls. So that means that a lot of assets are going to be pushed further down to panic level prices.

Now, to which assets and to which extent this is going to happen we're going to find out over the coming weeks, and perhaps the Bank of Japan can decide to reverse their policy before this gets even more entrenched. But at the same time, when you have trillions of dollars on your books, you should be worried. But the much bigger problem is the fact that the government of Japan itself is essentially involved in one massive 20 trillion dollar carry trade. The Japanese government's balance sheet as a percentage of GDP is around 505% now. Japan has borrowed so much in other currencies and relative to its own GDP that now by raising rates and strengthening the Yen it's all of a sudden creating a unique financial crisis that nobody has ever experienced before. At $20 trillion, the Japanese government's balance sheet effectively is one giant carry trade. I am surprised Japan has been able to sustain ever-growing levels of nominal debt for so long, but now that Japan is raising their rates, it's creating massive margin calls for their own national finances and their own national security.

One could argue that if Japan lowers their rates again maybe that would be fine, and certainly that might be a possibility. But long-term, that's not really an option - not if you want to protect your currency from further collapse. So, in other words, if Japan decides to continue making efforts to save their Yen, you could expect more of this carry trade-induced panic. Again, just this week alone (so far) we saw a wipe-off of around $1 trillion on just the start of this from the biggest stocks in the stock market (and trillions more if you look at the overall market). So, if this does fully unravel or only half of it unravels, you can expect a lot more downside pressure.

As I am writing this, the US Fed is holding an emergency meeting and perhaps an emergency rate cut. For context here, the Federal Reserve only convenes unscheduled emergency meetings to alter its policy stance in the most critical of situations. If you look at the long-term historical data, the last occurrence of an emergency meeting was on March 15th, 2020, when central bankers drastically reduced borrowing costs and the World drastically reduced borrowing costs to near zero as the COVID pandemic instigated widespread panic and disrupted global market functions. Yet at the same time, on Monday, the market decline was not as severe. Even at lows, it dropped less than half the amount of that one particular pandemic day. But there's a few other points that threaten the Fed's mission.

US unemployment data from Friday were bad, Earnings starting to weaken across the board, consumer sentiment has dropped, consumer debt is at unsustainable levels and going up aggressively, instability around the world, and Inflation is heading towards the Fed's target. Therefore, the idea that inflation should be a top concern right now is probably not very realistic. We're heading into a deflationary, recessionary, panicked environment right now and the Fed, who was far too late to raise rates, is likely going to be far too late to cut them. And that's what we are seeing right now.

But here's the flip side of this. If the Fed cuts rates now, there is likely to be a panic in the market because historically, the Fed only does this in the direst of situations. So, we are facing a double-edged sword and all investors can expect is massive volatility in the short term while Japan is offloading US bonds and other assets (Japan is the largest holder of US government bonds in the World) – if you think the Truss-Kwak-Kwak attack on our pensions was bad, buckle up for what’s still to come, in Japan, the US, and the rest of the World.