(Photo by Reuters)
“The traders hadn’t seen a move like that – ever. True, it had happened in 1987 and again in 1992. But Long-Term’s models didn’t go back that far. As far as Long-Term knew, it was a once-in-a-lifetime occurrence – a practical impossibility – and one for which the fund was totally unprepared.”
– When Genius Failed: The Rise and Fall of Long-Term Capital Management, Roger Lowenstein
The 1998 collapse of the hedge fund Long-Term Capital Management (“LTCM”) was a precursor to the Global Financial Crisis. It threatened the financial system, too, and ultimately required a private bailout and was “recapitalized with a fresh $3.65 billion” (Lowenstein, p. 221). While not a huge sum by today’s standards, the LTCM story has many lessons – hubris, blind faith in accolades, overleverage – the most relevant of which is encapsulated above. Even boasting a management team comprised of Nobel laureates, Wall Street traders, and executives with decades of experience, LTCM’s troubles began a mere five years after the previous shock. Their disregard for the cycles of history and the real-world interplay of currencies, rates, and markets practically ensured the fund’s demise.
THE CARRY TRADE AND ITS RISKS
Sam Meredith’s recent CNBC article posits that “the popular ‘carry trade’ is unwinding — and economists fear Fed rate cuts could make matters worse” (2024). Meredith is correct here, however the risk us not due to the Fed’s actions, per se, but rather because investors don’t adequately manage macroeconomic risk.
The carry trade to which he’s referring relies on a simple premise. Investors borrow in a low-cost currency, in this case the low yielding Japanese yen (the Japanese 2-Year is currently yielding about 35 bps). They then purchase other higher yield currencies (like the USD) and invest that inexpensive borrowed capital to into a higher return vehicle, such as US Treasuries yielding 4-5% depending on maturity. Thus, they’ve locked in a 3.5-4.5% return without utilizing their own capital and, in theory, little downside.
Of course, many investors are not satisfied with mid-single digit returns and decide that they could do even better in investments such as US equities. The S&P 500 is up about 17.5% YTD and has a long-term compound annual growth rate of around 12%. But the risks here are sizable.
First, we have the usual investment risk. US stocks have historically had huge drawdowns, losing 57% during the Global Financial Crisis, almost that much during the Dot-com Crash (the Nasdaq lost over 70%), and over 30% in a matter of weeks during COVID. And at the S&P’s current high levels, this is a real concern.
But ultimately, the yen carry trade brings its own additional risk, namely sudden adverse currency fluctuations. If the yen rises in value compared to the USD, then investors need more dollars to pay back their yen denominated loans which could eliminate years of carry trade profit. And to manage this, one must attempt to divine the actions of the world’s central banks or even, as we’ll see, the market’s expectation of future central bank policy – a formidable undertaking for even the most seasoned traders and illustrious economists.
HISTORICAL CONTEXT
The Bank of Japan (“BOJ”) has kept the yield on the yen lower for longer than that of any other currency. Following the 1990 crash of its equity market, which didn’t recover until February of this year, Japan’s unprecedented foray into quantitative easing “began in July 1991, with the first out of nine cuts that took place in the 1990s. In September 1993, the BOJ entered uncharted territory as the official rate reached an all-time low of 1.75%. Two years later, in September 1995, interest rates were at an unprecedented level of 0.5%” (Kowalewski and Shirai, 2023). Its target rates were actually negative from 2016 until March of this year.
With rates on the yen this low for this long, the carry trade has become a staple for many investors including “financial traders, businesses, and even individuals who have used the technique to pay for mortgages in their home countries” (Sposato, 2024).
THE RECENT “UNWINDING”
When any trade becomes this crowded, there’s always danger in a rush for the exits. We’ve seen this all play out dramatically in recent weeks as the “BOJ took markets by surprise with a double-barreled approach of raising the target interest rate on Japanese government bonds and announcing that it was sharply reducing the amount of bonds it buys as part of its efforts to control interest rates” (Sposato). On 31 July, the BOJ raised its target rate to 0.25%, the highest it’s been since 2008. It also outlined its intention to reduce the holdings of its massive “$3.9 trillion balance sheet by up to 8%” (Kihara and Yamaguchi, 2024) – this is especially significant given then that BOJ holdings are “nearly 1.3 times the size of Japan’s economy, the world’s fourth largest” (Sugiyama, 2024).
However, the true cause of the drop was that market participants were surprised by the BOJ’s actions. The results of a Reuters poll conducted just two weeks before the BOJ’s policy move concluded that “the Bank of Japan will skip raising interest rates at its policy-setting meeting at the end of July…more than three-quarters of economists said” (Sugiyama). This, combined with US employment numbers reported on 2 August coming much softer than expected and the US “unemployment rate rose to 4.3% from 4.1% in June, the highest level since October 2021” (Japan Times Editorial Board, 2024), caused markets to convulse as “Japan’s Nikkei index fell 12%, its biggest loss in three decades. South Korea’s Kospi plunged 9%, and the Nasdaq…dropped 6% at its opening” (Japan Times Editorial Board).
Following this turmoil, some investment industry analysts were calling for a more accommodative central bank policy:
…if the carry trade unwind really is a problem, we’d hope these central banks would take steps to introduce some form of quantity measures that would help prevent Japanese and other investors that have run on yen carry trades from having to sell assets, and facilitate the Fed cutting rates in due course without exacerbating financial fragilities,” economists at TS Lombard said. (Meredith)
As always, market participants want help when their trades move against them, seeking to privatize the gains and publicly share the losses (or the risk).
THE MANDATE OF CENTRAL BANKS
However, central banks have very specific mandates, and while that may involve quelling market volatility or precipitous falls in times of panic, that is not the primary goal. Federal Reserve Board of Governors member Lisa Cook outlined the Fed’s mandate in a speech in March, saying that “The Fed’s modern statutory mandate…is to promote maximum employment and stable prices. These goals are commonly referred to as the dual mandate” (Cook, 2024, Harvard University). Other central banks, the BOJ included, follow similar mandates. One will note that this does not include protecting the market prices of securities. As the saying goes, Wall Street is not the economy, and protecting Main Street, or the real economy, should be the aim of monetary policy.
INVESTORS ASSUMPTION OF RISK
Investors, on the other hand, are ostensibly compensated by their returns for the assumption of risk. They are professional investors with teams of experts assembled for the sole purpose of generating returns for themselves and for their clients. Major problems arise when they become complacent and greedy. We saw this with Long-Term Capital, with he near collapse of the financial sector that began the Global Financial Crisis, and we see it again now in the yen Carry Trade.
When the yen rocketed up compared to the dollar investors should have been prepared. William Sposato again puts it succinctly:
In mid-July, the dollar was worth more than 161 yen, but by the end of the Asian trading day on Monday [5 August], it stood at 142 yen, a 12 percent fall in value. That would easily wipe out a year’s worth of yen carry trade interest payments. Small wonder that there was an increasingly hectic race for the exits. (2024)
With the BOJ having kept rates low for decades, investors have been lulled into a false sense of stability. But it is their responsibility, especially as professionals and as stewards of their clients’ investments, to anticipate and hopefully mitigate possible risks (of course, there are many tools to help: futures, options, even custom swaps, but the associated expense of those reduces return).
As the BOJ moves to tighten, the Fed will likely begin to cut rates in September, as Chairman Powell telegraphed in his recent speech in Jackson Hole: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks” (Powell, 2024, Jackson Hole). Regardless, it is incumbent on investors to remain steadfast students of history and its cyclical nature. We’ve seen this play out many times before. And the unwinding of this trade could be far from complete.
If you’re looking for a strategy that is designed for paradigm shifts and multiple environments, at Taylor Morgan Capital our dynamic, proprietary investment approach does just that:
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If you’re interested in the possibility of avoiding the worst of the next paradigm shift and even the possibility of profiting during challenging times, we’d love discuss our investing approach and see if it’s a fit.
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