The US Dollar Wrecking Ball & the End of the Last Great (Japanese) Carry Trade?
"Our Dollar, Your Problem" as the US Dollar wreaks havoc, plus the risks to global markets as the Bank of Japan contemplates major changes to YCC and NIRP
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This Insight is an extract adapted from the Panah Fund letter to investors for Q3 2022.1
TABLE OF CONTENTS
“Our Dollar, Your Problem”
The proverbial US Dollar wrecking ball has cut a swath of destruction through world markets in 2022. The first to succumb were more vulnerable Emerging and Frontier Market nations such as Sri Lanka and Pakistan – pre-existing weaknesses were compounded by policy errors, leading to tragic outcomes.
Next up to the chopping block were various overextended and complacent developed countries in Europe, where policymakers seem to be doing their best to have their economies reclassified as ‘submerging markets’.
Germany has been learning the hard way about the dangers of being highly dependent on one energy source, while the markets have taught UK politicians a lesson about why an overindebted nation should not overstimulate its economy into an inflationary bust. (After all, Sterling has not been the reserve currency for the best part of a century.)
Such periodic crises are of course a feature of the US Dollar-based international monetary system rather than a bug. As US Treasury Secretary John Connally told a group of European finance ministers during the Nixon Shock in 1971: “The dollar is our currency, but it's your problem.”
In 2022, the Fed has belatedly moved to chase inflation and tighten monetary policy, rapidly pushing interest rates higher. This has roiled bond markets, and interest rate differentials have provided support to the US Dollar. Other factors have also boosted the greenback – the squeeze is on as companies and countries scramble for dollars to pay down dollar debts and unwind forex hedges.
For those with US Dollar liabilities and no way to service them, the comedown has been brutal. Chinese real estate developers – caught between ‘Zero Covid’ and regulatory tightening on one hand, and tighter US monetary policy on the other – have seen the value of their US Dollar bonds eviscerated. The Markit iBoxx USD China Real Estate High Yield Total Return Index has plunged by ~-82% since from the highs of May 2021. According to some accounts, the credit market for this sector has effectively ceased to function.
Credit investors in the rest of Asia are rightfully nervous. In recent days, the threat of a redemption delay for a callable US Dollar perpetual bond by Heungkuk Life Insurance was enough to cause panic as investors started worrying about solvency issues in the Korean financial sector.
So long as the Fed continues to tighten monetary policy, it is hard to imagine that the US Dollar will turn a corner and global markets will be able to find a bottom. Indeed, the Fed will probably succeed in breaking every other asset market before the US economy finally rolls over.
Japan – the End of the Last Great Carry Trade?
Are there any other risks hiding out there?
We believe that the next geta to drop may well be Japan.
Governor Kuroda of the Bank of Japan (‘BoJ’) has stubbornly insisted on maintaining Negative Interest Rate Policy (‘NIRP’) and Yield Curve Control (‘YCC’) even as other central banks around the world have followed the Fed and started to raise rates.
The justification given is that inflation in Japan is tracking well below the level of other developed countries given the ‘embedded deflationary mindset’ in the country. According to Governor Kuroda, it is this mindset which needs to be changed (signalled by an increase in inflation to >2% on a sustained basis), before the BoJ will yield on YCC and NIRP.
So far, this policy has contributed to widening interest rate differentials with other developed nations and a rapidly depreciating Yen (-22% YtD to end-October 2022).2 The Ministry of Finance (‘MoF’) has also experienced mounting costs in the form of foreign exchange reserve depletion as a result of forex intervention to support the Yen.
Ironically, when the MoF sells foreign bonds (i.e., US Treasuries) to buy Yen, this has the unintended effect of helping to push global yields higher, thereby intensifying the pressure on the Yen and contributing to the vicious cycle of Yen weakening.
The BoJ has committed to keep its key short-term interest rate at -0.10% and to maintain 10-year bond yields around zero percent. In practice, the central bank buys unlimited amount of bonds to cap the 10-year yield at 0.25%.
As a result, the BoJ’s ownership of the Japanese bond market increased to more than 50% in June 2022. Recently, the BoJ has bought all newly issued 10-year JGBs and more. At the current low, BoJ-determined yields, it appears that nobody other than the BoJ wants to own JGBs. If this trend continues, it will not be long before the BoJ owns so many JGBs that trading will dry up completely.
Unsurprisingly, the yields on longer-dated bonds are now trading at materially higher yields than the 10-year maturity. If the BoJ were to pare back its bond purchases and leave markets to their own devices, the implication would be that yields across the curve would likely gap up. As yet, the BoJ has not blinked and has instead doubled down with purchases, but is it just a matter of time?
With Governor Kuroda’s term set to finish in April 2023, it is unclear whether any new governor would support a continuation of the current monetary policy settings. And if inflation in Japan continues to rise (Japanese core CPI recently hit an eight-year high of 3.0%), then it is even possible that the BoJ might move to adjust monetary policy before that time.
The BoJ’s first step away from extreme monetary easing might be a small one, for instance raising the ceiling or abandoning YCC for ten-year bonds and attempting to maintain the policy at shorter maturities. Even a small change, however, would likely have an outsized impact.
Any attempt to maintain YCC at shorter maturities would probably lead to a massive spike in ten-year yields (meaning large mark-to-market losses for the BoJ). Once the BoJ starts to bend on policy, however, the situation is unlikely to settle down quietly. Instead, the markets will likely push the central bank and its NIRP-YCC policies to their breaking point.
When any peg breaks, no matter whether in the currency or the interest rate markets, the results can be breathtaking. Japanese interest rates are the last developed market low-rate anchor left in the world. The Yen is also the last low-interest funding currency for a massive global carry trade. The unwind thus has the potential to be spectacular.
If ten-year yields were to gap up to above 1% in short order, and the Yen were to strengthen by ~20 big figures in a short period of time, there would be the potential for serious market mayhem as Japanese domestic investors divest foreign investments and repatriate their savings.
The Japanese economy is habituated to cheap and readily available credit, especially the real estate sector. It is also uncertain how much debt that Japanese real estate funds and private equity companies have taken on. Only when Japanese rates move higher will we all find out which companies and individuals, in which parts of the world, have been leveraging up their balance sheets with cheap Yen loans.
Optimists should thus be hoping that price pressures remain subdued in Japan for as long as possible!
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
Other factors have also contributed to Yen weakness, including Japan’s growing current account deficit (to which rising energy costs have been a significant contributor).
