The financial markets will disappoint your yen for stability
Summary
The Japanese currency’s rapid appreciation could serve to trigger a global financial emergency.
As we go to press Thursday financial investors are already choosing to forget the tremors that hit global markets Monday. The theory appears to be that after a brief period of policy-induced upset, global finance has stabilized and we’re out of the woods. Alas, dear friends, we’ve barely wandered into the forest.
To see why, it helps to understand the most important phenomenon of this week. It wasn’t the stock-market dips on Wall Street or in Europe, as unpleasant as they were. It was, and is, the rapid appreciation of the Japanese yen, a currency that now joins U.S. commercial real estate on that elite list of potential triggers of a global emergency.
Emphasis on “rapid." The yen hit a 38-year low of ¥162 to the dollar in early July. By Monday it had surged to around ¥144, a 12.5% jump, and now appears to be stabilizing around ¥147.
Of significance for global markets, this yen swing likely is different from the currency’s oscillations in recent years. Yen trading of late has been marked by a pull and push between traders trying to pull the currency down and a worried Finance Ministry intervening sporadically to push it back up. Now, however, the central bank is getting involved.
Bank of Japan Gov. Kazuo Ueda last week described an excessively weak yen as “an important risk" to the economy and said the exchange rate was “one of the reasons for the policy decision" to increase the short-term interest rate to 0.25%. It’s rare for a developed-economy central banker to comment so bluntly on exchange rates. Bet against a finance ministry all you want; a bet against a determined central bank tends to lose. Memo to markets: A yen near or below ¥160 isn’t coming back. This statement probably had a bigger effect than the rate increase itself.
We’ve already seen one consequence at the Tokyo stock market. The mass selloff of Monday and last Friday can be attributed largely to foreign investors’ cashing out. Having bought into the market when the yen made investments appear cheap in foreign investors’ home currencies (and inflated the yen-denominated profits of Japanese companies), it made sense to sell as appreciation becomes the norm.
Then there’s the infamous yen carry trade: the process by which an investor borrows yen at Japan’s ultralow interest rates to invest in a foreign market at a higher interest rate. The aim is to profit from the difference in rates between the two economies and, the investor hopes, from a further depreciated yen by the time the loan comes due.
Everyone knows this carry trade is large, but no one can say how large. Globally, net credit in yen extended by a bank in one country to a nonbank financial company—say, a hedge or pension fund—in another country stood at around $834 billion as of March, according to Bank for International Settlements data, up from $493 million in late 2014. Yen credit outstanding to nonbank financial companies in the Cayman Islands (a hub of this investing) stood at $382 billion as of March.
Not all of this lending can be traced to carry trades—there are many possible reasons for such borrowing—and not all carry trades are financed via loans visible on bank balance sheets. But these and other data points hint that the magnitude of the carry trade is substantial. The effects were visible this week. It appears the yen’s surge was fueled in part by margin calls on carry-trade-linked lending, which forced investors to buy yen to post collateral.
The carry trade is only one part of Japan’s interaction with the global financial system, however, and perhaps not the most important. The country has been a source of enormous quantities of outbound financial investment. Its outbound portfolio investments hit ¥617 trillion—or $4.2 trillion—as of the end of December, up from ¥531 trillion a year earlier, according to Finance Ministry data. Japanese holdings of U.S. Treasury securities alone stood at $1.1 trillion as of May.
Many and perhaps most of these investments aren’t leveraged in the way carry trades are. They’re still sensitive to the difference in interest rates between Japan and other markets, and to the value of the yen. Even before this week, Japan’s two largest life insurers—Nippon and Dai-ichi, with combined assets of ¥120 trillion, of which ¥28 trillion are invested in foreign securities—had announced that shifting interest and exchange rates were prompting them to scale back overseas bond purchases.
The rapid unwinding of leveraged-carry trades is only part of a broader realignment of Japanese and global portfolios as the Bank of Japan returns domestic interest rates to something resembling normal and the yen to valuations that match. Don’t expect the process to be quick, or easy.
