The Fed Meeting Isn’t the Only Rate Decision to Watch. Why Japan Could Matter More.
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The unwinding of the yen carry trade that was blamed for August’s short-lived market turbulence might not be finished yet. That makes the Bank of Japan, not the Federal Reserve, the most important central bank meeting this week.
All eyes, of course, are on the Federal Reserve. Fed Chair Jerome Powell and company are widely expected to lower interest rates on Sept. 18. The usual rule of thumb is that cuts help stocks by making them relatively more attractive to bonds and making it easier for companies to borrow. But that might not be the case this time around, if the Bank of Japan surprises with another interest-rate increase at its next meeting on Sept. 20.
That’s because the cut reduces the difference between the benchmark U.S. and Japanese rates, and interest rate differentials are one of the key factors that currencies respond to. The BOJ is widely expected to keep rates on hold after lifting its key rate from close to zero in July, but that’s far from a certainty.
“Financial markets are definitely interested in how quickly the Bank of Japan hikes rates,” said ING strategist Chris Turner. “It could certainly cause more volatility if there were unexpected tightening.”
Higher interest rates in Japan make the yen carry trade—where you borrow money in the Japanese currency and invest it in higher-yielding assets elsewhere—less popular. While there’s still a big difference between the 5% rate in the U.S. and Japan’s 0.25%, the margin is getting smaller. And the strengthening of the yen against the dollar increases the pain because the traders have to pay back more in dollars than they borrowed.
“Most of the short-term carry trade, say 99%, has unwound,” said Yusuke Miyairi, an economist at Nomura. “But there’s still the medium- and longer-term carry trades that will take years to finish. It’s now clearly less attractive.”
Nomura sees the Fed cutting three times this year and four times next year, bringing the key rate to a 3.5% to 3.75% range. At the same time, it expects Japan to slowly raise its benchmark to 1% by the middle of next year. That roughly 2.5 percentage point gap is a lot smaller than at the start of the year.
For years, money borrowed for next to nothing in Japan was funding a lot of speculative bets. People weren’t necessarily borrowing yen just to buy Nvidia and other Magnificent 7 stocks—assets in places with higher interest rates, like Mexico, were a more popular destination. And in fact higher-yielding currencies such as the Mexican peso, Brazilian real, and South African rand fell the most as the yen appreciated last month.
But borrowing in Japan did provide liquidity for financial markets globally. Now that the bet is going the other way, some of that money is being drained from the system, in both direct and indirect ways.
“When forex volatility rises, it increases a metric called value-at-risk,” or VAR, measuring how much money could be lost in a trade, said ING’s Turner. “Risk managers will then tell traders to downsize their portfolios,” he said. “It’s the volatility channel that can really trigger shrinking position sizes.”
What’s more, using borrowed money for trading magnifies both gains and losses. The risk is that, if things get worse for the carry trade—if the yen appreciates more or the interest-rate gap narrows further than currently expected—there’s a chance traders will have to sell off more assets to pay back loans.
Nevertheless, ING’s Turner said that the movements of the yen—the most obvious sign of the carry trade reversing—should become more orderly now.
When the Covid-19 pandemic hit in early 2021, the yen traded at around 105 to the dollar. Since then, the carry trade has become much more popular, pushing the currency’s value down. By mid-July of this year, it traded at 160 to a dollar.
On Monday, it strengthened to lower than 140 for the first time since last year—a fall of more than 10% in the value of the dollar, a huge move for normally stable currencies. The yen could go to 135 by the end of the year, ING predicts, a decline of almost 5% for the dollar from current levels.
“A lot of leverage had built up, and it burst starting in July,” Turner said. “You’re unlikely to see the same dislocation again.”
But less violent swings could still mean bigger moves than investors are used to. At least as a source of liquidity and credit, the carry trade “could be a volatility factor that’s not on everybody’s radar because they think we went through this already,” said Arnim Holzer, global macro strategist at Easterly EAB Risk Solutions. “Volatility will remain a little bit higher for longer, until the Fed is able to reach a number where rates actually stabilize. We think investors should have some exposure to products that benefit from volatility.”
That’s another way of saying that stock prices could move around—a lot—and that investors need to be prepared to stomach it. They might also consider an exchange-traded fund tied to the CBOE Volatility Index, or VIX, to take advantage of the moves. Examples include the iPath Series B S&P 500 VIX Short-Term Futures ETN and the ProShares Short VIX Short-Term Futures ETF.
Yes, the Fed and the BOJ will do their best not to surprise the markets as interest rates adjust over the next few months. But trying and succeeding are two different things. There could certainly be more bumps in the road.
What are the potential implications of an interest rate cut by the Federal Reserve?
A rate cut by the Federal Reserve can have several significant implications for the economy and financial markets. Lowering interest rates decreases the cost of borrowing for both consumers and businesses, which in turn stimulates spending and investment. More affordable loans can result in elevated borrowing for mortgages, vehicle financing, and business growth.
While lower interest rates can stimulate economic growth, they may also result in higher inflation if demand exceeds supply. This inflation can diminish purchasing power, impacting consumers' capacity to purchase goods and services.
Lower interest rates frequently lead to an increase in stock prices, as investors look for higher returns from equities. When interest rates decrease, bond prices usually climb, since bonds with higher yields become more desirable. Additionally, a reduction in rates may devalue the dollar, which can make U.S. exports more competitive, but also raise the cost of imports.
Interest earned on savings accounts and other fixed-income investments might decline, impacting savers. Consequently, investors may shift their funds from low-yielding savings to higher-risk assets such as stocks or real estate. Reductions in interest rates can result in heightened market volatility, particularly when the economic forecast is unclear.
The unwinding of the yen carry trade may intensify this volatility. As investors liquidate their positions, this can precipitate abrupt and substantial fluctuations in the values of currencies and stock markets. A reduction in the Federal Reserve's interest rate usually leads to a weaker dollar, which makes U.S. exports more competitive while raising the cost of imports. Conversely, the unwinding of the yen carry trade results in a stronger yen, as investors pay back loans denominated in yen. This can cause a rapid increase in the yen's value, affecting global trade and investment patterns.
Both scenarios can result in stock market sell-offs. Historically, the unwinding of the yen carry trade has triggered substantial sell-offs, especially in U.S. tech stocks. While lower Federal Reserve interest rates may result in higher bond prices, the heightened volatility from the yen carry trade unwind can introduce uncertainty in the bond markets. The cumulative impact of these events may create a more risk-averse climate. Investors could gravitate towards safe-haven assets such as gold and government bonds, shifting away from high-risk assets in favor of stability found in lower-risk investments. ⚡ This could cause gold to continue to see ATH's followed closely by silver.
Consequently, central banks and governments might have to implement further measures to stabilize their economies and financial markets. The last time events like these were in play was during the 2007-2008 Financial Crisis. The Federal Reserve aggressively cut interest rates to combat the crisis. As global financial markets destabilized, investors unwound their yen carry trades, causing a sharp appreciation of the yen. The rate cuts combined with the unwinding of yen carry trades led to significant market volatility and a flight to safety, with investors shifting to less risky assets. These events have led to today's turmoil, suggesting that history may repeat itself, with similar occurrences happening consecutively.