Japan had dropped abundant hints that interest rates would inch up: a semblance of normalcy in monetary policy had to return; fears of inflation were building up; and, outflow of yen (to bet on stocks) amid a drop in financial savings can’t go on. It was only a matter of time that the yen had to get pricier.
Over the years yen and the Swiss franc, thanks to low or near zero interest rates, had come handy to the big boys of the world market to play around with borrowed money. That arithmetic comes under stress when yen becomes costlier, as it’s beginning to happen now with Japan raising rates. A more expensive yen drives these leveraged investors to sell their stocks in the US and emerging markets, convert the money back into yen and repay lenders. This unwinding of leveraged trades is giving way to a sudden volatility. It’s a familiar plot-it has happened before, it could happen again.
Macro funds, which take large positions based on factors like currency and interest rate, and hedge funds are among the dominant players in the yen carry trades. Guided by ‘value at risk’ limits-a statistical yardstick to measure the riskiness of portfolios-these funds sell off when they suspect their bets could backfire due to adverse movements of macro indicators like Japanese interest rates or US unemployment.
The two events, coming in quick succession, provided adequate ground to sell by not just leveraged investors but even those global investors who, having made a lot of money in a long rally, would choose to pause and sit on cash for a while. With cross-border yen borrowings estimated to have risen $750 billion since 2021 to over $2.5 trillion, more unwinding, sparked by more data from the US, can be unsettling.The question is: how bad are the US numbers? Is higher US unemployment merely a reflection of greater participation of workers in the job market compared to creation of new job opportunities? Is the number up simply because more Americans, who were idle for months, are looking out for jobs? Is it then a somewhat misplaced concern? US corporate and household balance-sheets are not particularly weak. Besides, liquidity is not going out of the market with central banks not (and unlikely to) pulling back surplus money.For Japan, which raised rates by a quarter point (for the second time since 2007), it was no longer possible to defer the decision with the citizens sensing the inflation on the back of rise in food prices. But, it’s the Japanese who are hurt the most when the yen rises on the back of higher interest rates and carry unwinding.
This is showing up in the fall in the stock prices of Japanese companies, many of which have high reliance on exports. Even as Japan tries to pull itself out of a deflationary rut and move away from the ‘yield curve control policy’ which was in place since 2016, aggressive moves would be tempered by shallow domestic demand and adverse impacts on exports.
Nonetheless, analysts and markets are often haunted by a looming spectre of a possible “stall speed”-the pace at which an economy must move, failing which the growth engines sputter to a halt. But with the US growth improving to 2.8% in the April-June quarter (from 1.4% in the previous three months), how valid is the concern? Economists in some of the leading MNC banks have argued that a softening labour market and consumer spending do not bode well for US growth in the third and fourth quarter of 2024 as slowdown can often be non-linear and abrupt. The jury is out on this. Till then, tossed by such arguments and counter-arguments, markets would lose some of its froth. It may not necessarily mean a catastrophe.
