4 Alpha Research Researcher: Kamiu
Opinions in a nutshell
After the July macro week, the U.S. dollar, gold, and Bitcoin all fell simultaneously. Generally speaking, these three assets are more likely to move in the opposite direction.
This is mainly due to the need for margin calls on Japanese yen carry trades, which has led to a sharp increase in liquidity demand, and a large number of gold and Bitcoin positions have been closed to provide US dollar liquidity.
The interest rate hike by the Bank of Japan reflects the attitude of the Japanese monetary policy authorities to maintain the yen exchange rate. There is no obvious causal relationship with asset prices in the long run, but it may have a more far-reaching impact on Japans macro-economy, and have a greater impact on Japans foreign trade and high-end manufacturing reconstruction.
1. The small probability event of the simultaneous decline of the US dollar, gold and Bitcoin in July occurred, mainly due to the temporary liquidity shortage caused by the reversal of the yen carry trade
Historically, it is a low probability event that gold and Bitcoin denominated in US dollars will fall sharply at the same time. First, the US dollar denominated means that the US dollar prices of both are naturally negatively correlated with the US dollar index. When the US dollar is strong, gold and Bitcoin will appear relatively weak, so gold and Bitcoin will change synchronously with the changes in the US dollar index; secondly, Bitcoin and gold are assets that are not controlled by sovereign monetary policy authorities, have anti-inflation characteristics, and are highly liquid. The consistency of their inherent characteristics also leads to their prices generally showing a positive correlation.
As asset classes that are negatively correlated with the US dollar index, for gold and Bitcoin, when the prices or yields of US dollar-denominated assets such as US Treasury bonds fall, it is generally understood that the prices of gold and Bitcoin should rise due to capital inflows. However, in early August 2024, as a series of important economic data such as the US non-farm payrolls in July and the second quarter CPI were far below expectations, the signs of economic slowdown and even recession intensified, and the Feds September rate cut was almost a foregone conclusion, the US dollar index plummeted while the prices of gold and Bitcoin also fell sharply.
We believe that this is mainly due to the reversal of the yen carry trade after the Bank of Japan announced its first interest rate hike after exiting YCC at the end of July. After the Japanese economic crisis in the 1990s, in order to alleviate the common balance sheet problems and bank runs of primary market makers, Japans monetary policy entered a long period of low interest rates to combat strong deflationary pressure, and the interest rate differential between Japan and the United States widened. After entering the 21st century, due to the impact of the 2008 subprime mortgage crisis and the slow action of the Bank of Japan, the Japanese economy suffered a more serious impact. At the same time, the aging population also led to increasing pressure on pension and medical insurance expenditures, and fiscal pressure, which eventually led to Abes economics having to adopt a more radical negative interest rate policy and a larger-scale QE expansion. Against this background, the interest rate differential between Japan and the United States further widened, and the yen carry trade came into being.
Specifically, carry trade is a trading model that uses extremely low yen exchange rates to borrow yen and then converts them into dollars to hold dollar assets. Traders of this type of carry trade are also nicknamed Mrs. Watanabe. Under carry trade, you can basically enjoy the long-term interest rate difference between Japan and the United States of more than 3% (up to 5% in recent years) without risk. Therefore, in recent years, carry trades based on the amount of financing of overseas investors in Japan have become increasingly active. For example, Buffett previously borrowed a large amount of yen funds to buy Japanese stocks because the cost of financing in yen is relatively the lowest among major currencies.
Due to the Bank of Japans unexpected rate hike (policy rate) and the unexpectedly hawkish speech by Bank of Japan Governor Kazuo Ueda, Japanese market interest rates, yen exchange rates and Japanese bond yields have soared simultaneously, and the interest rate differential between Japan and the United States has narrowed significantly in a short period of time. It is no longer profitable to continue to carry interest rates and even turn into losses. For many Mrs. Watanabe around the world, in order to avoid forced liquidation of positions, they can only choose to liquidate other safe-haven asset positions (gold, Bitcoin) and convert them into US dollars for margin calls. This process has led to huge instantaneous selling pressure on Bitcoin and gold, which has led to the relatively rare phenomenon of the simultaneous plunge of the US dollar index, gold and Bitcoin.
Therefore, the plunge in gold and Bitcoin after the yen rate hike was more due to accidental factors at the cash flow statement level, rather than other macroeconomic fluctuations or cryptocurrency fundamentals. At present, the long-term interest rate spread between the US and Japan has fallen back to below 3%. At the same time, as shown in the figure below, the US dollar against the yen continued to plummet after the rate hike, increasing the cost and difficulty of the yen carry trade, indicating that the decline in carry trades will continue for some time, and the author initially estimates that it will be around 3-5 months.
2. Historical data shows that except for Japan-related assets, the reversal of the carry trade does not have much asset price implications
In addition to causing a short-term shortage of US dollar liquidity and abnormal price movements of safe-haven assets, the reversal of carry trade will not have much impact on other assets except the yen and Japanese bonds in the long run, and there is no very obvious reaction pattern or causal relationship. After the bubble economy burst in the 1990s and the yen became the main carry trade currency, there have been 5 rounds of carry trade reversals in history. In addition to the reversal of carry trade leading to capital flowing back to Japan, the procyclical acceleration of the yen exchange rate and the rise in Japanese bond yields, global stock assets have different reactions to each round of carry trade reversal.
In 1998, 2002 and 2007, although Japan and the United States simultaneously entered the downward interest rate channel, the Bank of Japans interest rate cuts were not as strong as the Federal Reserve, resulting in a narrowing of the Japan-US interest rate gap and a reversal of carry trades. In 2015, the market expected the Federal Reserve to end the interest rate hike process, and in 2022, the Bank of Japan raised the YCC and 10-year Treasury yield targets. Although the Japan-US interest rate gap did not narrow significantly, the market strongly expected a decline in the Japan-US interest rate gap based on the above reasons, and the carry trade also fell and reversed. However, the reactions of global stock markets in the above five rounds of carry trade fluctuations were not consistent. In 1998 and 2022, the global stock market performed well, but the other three times the global stock market performed poorly, making it difficult to summarize a more reliable guiding law.
3. However, the reversal of the carry trade will accelerate the process of yen interest rate hikes, which may have a profound impact on Japans macro-economy.
The yen exchange rate and the reversal of carry trades present a logical transmission chain of spider-web-like spiral reinforcement. The central banks interest rate hike leads to a narrowing of interest rate spreads and a reversal of carry trades. The reversal of carry trades leads to capital inflows and yen appreciation. The expansion of returns on holding yen-denominated assets further weakens the motivation for carry trades, forming a reinforcing cycle. Faced with the yen exchange rate that has plummeted this year, the Bank of Japan has resolutely implemented interest rate hikes to maintain the stability of its currencys purchasing power. It is understandable that the yen exchange rate is openly protected. However, faced with the old-fashioned problem that the yen exchange rate rise hurts the Japanese economy, the current Japanese policy authorities do not seem to have given a good solution.
Here, this article wants to explore a paradox that is often mentioned: Japans foreign trade economy does not seem to account for that large a proportion of its GDP. Why do we always emphasize the impact of exchange rates on Japans foreign trade and why do we always emphasize that Japan is an export-oriented economy?
The reason is that Japans exports are mainly industrial products, especially automobiles. The automobile industry chain, especially fuel vehicles, is extremely long, which can provide a large number of direct jobs in the secondary industry (upstream spare parts factories, etc.) and supporting jobs in the tertiary industry (the tertiary industry next to the industrial cluster that serves industrial workers). The production efficiency of Japans automobile manufacturing industry is obviously more advanced than other non-trade sectors such as the service industry. Due to the existence of the Balassa-Samuelson effect (as shown in the figure below), the high wage level of the manufacturing trade sector will be quickly transmitted to the non-trade sector, driving the development of the entire Japanese economy, and this effect is far higher than the role reflected by the narrow foreign trade GDP ratio. At the same time, large Japanese automobile brands such as Toyota and Honda have built factories overseas and sold directly locally (such as domestic joint venture cars). This part is not included in GDP, resulting in the underestimated role of the export-oriented export industry in the pillar of the Japanese economy.
Therefore, under the premise that domestic demand in Japan is still weak, the sharp rise in the yen exchange rate is hardly good news for the Japanese auto industry, which is struggling with Chinese autos worldwide, and the Japanese semiconductor industry, which is trying to revive its past glory. In the past 30 years, Japans economic and policy authorities have been desperately fighting deflation. Even if they did not adopt any tightening policies, just a little slower than the Feds loose policy, it would lead to a significant weakening of the economy. This time, the Bank of Japan showed a clear hawkish attitude for the first time in many years, which undoubtedly cast a shadow on the future of the Japanese economy in the short term.
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