The carry trade has gone out of fashion

Outlook:

The FT quotes an analyst speaking of the Swedish Rikbank move deeper into negative territory that it’s a sign of desperation. We might say the same thing of the BoJ, whose move into negative deposit rates on new reserves, modest though it was, set off a wave of selling of Japanese assets. Even the calm demeanor of Fed chief Yellen did not disguise the core message—global market turmoil threatens US growth. The seemingly logical deduction from that message is that the Fed remains on hold indefinitely. Yellen ruled out a cut back to zero during the Q&A, but honestly, that’s a best guess right now, not a promise.

We have two communications failures today that are setting up markets for more uncertainty and volatility. And then we have the perpetual problem of the yen being a market plaything and failing horribly to reflect economic fundamentals.

First the Fed. Yellen’s speech was so neutral that nobody came away with a clear idea of what the Fed expects to be doing in March or June or any other time. It’s obfuscation of Greenspanian proportions. You can see dovishness or hawkishness and defend either with equal plausibility. Personally, we heard optimism that conditions would allow a hike, but we respect those who see the opposite, including the major financial press reports (even if they get their slant from the equity crowd).

Here’s the important thing: Fed funds futures point to no more hikes this year, or maybe one at best. Unfortunately, we suspect that Chief Yellen doesn’t care what the Fed funds futures market is reflecting. We know Fed funds futures are a lousy predictor of actual eventual rates. Viewed in only that manner, they don’t count. Looked as a barometer of market sentiment, they speak volumes. But the Fed is not listening.

It’s never a healthy thing when the market disagrees with the Fed. We have always had nay-sayers, of course, but the divergence in outlooks is getting worse, not better. As long as the Fed was in ZIRP mode, everyone was happy to accept that rate hikes were in the far distant future. But the minute the Fed started talking about the eventual ending of zero rates, the fixed income market rebelled. Bernanke got the short end of a sharp stick (the taper tantrum), and Yellen has not gotten much better treatment, so this has been going on for a long while and has become an authentic trend. Disrespecting the Fed can’t be a good habit. And it’s not the market’s fault. It’s the Fed’s fault.

The only cure for this problem is the Fed going out of its way to step down from its ivory tower and engage with market-makers and opinion-makers. Yellen fully appreciates transparency and the Bernanke Fed had made a fetish of it, but transparency that is mostly “maybes” is not working. Unless and until the Fed engages the market more fully, we have opposing camps that set up strain and stress in all the markets, including not only the stock market but also FX. Central banks don’t like to disclose much for the obvious reason that some slick Willies will be able to make a quickie profit. Tough. The Fed should do it anyway, starting with sit-down meetings and press leaks and as many white papers as they muster to throw at the market. Respectful disagreement is okay. Disrespectful disagreement is a threat to financial stability.

Another big issue today is “What does China want to achieve after the New Year and does China have a chance of getting it?” Here is another communications failure. We honestly don’t know what China wants. Does it want the market to devalue the yuan so the PBOC/government can avoid charges of manipulation? That would imply the interventions were for show and not actually trying to halt the speculators. How about the stock market? It’s easy enough to get the slide to stop—do what Deutsche Bank did, speak of a stock buy-back.

The Chinese government can presumably strong-arm the big companies on the exchange to do precisely that. And what about getting rid of non-performing loans? European countries have led the way—invent a “bad bank” and put the junk in there, cleaning up the Big Four. Maybe China wants all of these things, or none of them, or something else entirely.

The fact that we don’t know what China wants is a scary thing in its own right. And given that world stock markets has fallen further down the cliff this week while China is on holiday, it’s a realistic assumption that investors in the Shanghai will play catch up the minute the Shanghai re-opens. Oh, good, just what we need—another crisis in China and ham-fisted response. It is China’s new responsibility to keep it under control somehow. Re-instituting circuit-breakers, big ones, would be a good start.

And on to Japan, where the dollar/yen is falling off the cliff from the high only two weeks ago at 121.69 (Jan 29) to 110.99 so far today. By any measure, this is a giant move and promises to become historic. The chart below is a monthly chart. It shows the potential extent of a retracement of the last big move, from 75.58 in Oct 2011 to 125.86 in June 2015. A classic Gann 50% retracement would take the dollar/yen to 100.73, a level not seen since April 2009. The current month so far has the biggest bar since Oct 2008, and we are only 11 days into the month. Those dates should be setting off warning sirens in your head. What was happening in Oct 2008 to April 2009?

The WSJ offers an explanation for the current move, writing that “The proximate cause for the yen to hit 111 against the U.S. dollar Thursday—8.5% stronger than just after the Bank of Japan dipped it toe into negative rates—is the unwinding of a hugely popular investment strategy by offshore investors to buy Japanese stocks while shorting the yen.

“When foreigners sell Japanese stocks, they simultaneously close out those short yen positions. This causes the yen to rise, which investors see as a further sell signal on stocks, since so many Japanese companies are reliant on a cheap currency to remain profitable. It is a classic feedback loop with market-shattering consequences. And foreign investors matter a lot in Japan. They make up 60% of trading on the Tokyo Stock Exchange. A decade ago it was 38%.”

What spooked equity players in the first place was the negative rate, a signal that Abenomics is failing. The BoJ also had bad timing. And the biggest losers are the pensioners with money in the $1.13 trillion Government Pension Investment Fund, which only recently (last fall) was prodded into diversifying out of government bonds into equities, including foreign equities. Equities are now 43% of the GPIF portfolio.

Because it’s Japan, we have to ask whether intervention is in the cards. Here the outlook is murky. Japan keeps promising not to intervene and then keeps doing it in the name of managing disorderly markets. In recent years, G7 and G20 have renewed the commitment not to manipulate exchange rates, most notably after the Brazilian finance minister accused the US of “currency wars” and again a few years ago when the Abe was the incoming PM in Dec 2012. At the time the dollar/yen was ¥84.38. Abe said "Central banks around the world are printing money, supporting their economies and increasing exports.

America is the prime example. If it goes on like this, the yen will inevitably strengthen. It's vital to resist this.” Ahead of Abe becoming prime minister, Japan intervened during October 2011. On Nov 1, FinMin Azumi defended intervention as “within the scope” of policy and he was engaging in a battle of nerves with markets that were “far from reflecting the economic fundamentals of his country,” as the FT reported at the time. Dollar/yen was at a crisis level of 75.35 and the intervention hauled it up over 5% that day.

At G7 in Feb 2013, the joint statement made a sideswipe at Japan, repeating the "longstanding commitment to market determined exchange rates" and the pledge to "consult closely in regard to actions in foreign exchange markets….. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate."

Here’s an interesting point: Japanese intervention over the past few years has been directed at specific conditions, including corporate exporters’ profitability. We did not see intervention during the 2008-09 financial crisis itself and that is what is most like conditions today. Intervention can be justified on the grounds of preventing disorderly markets—as when G7 intervened jointly with Japan after the Tsunami in March 2011. We guess the phone lines are burning up between Washington and Tokyo, with the US urging Japan to increase the negative yield from just new reserves to all reserves or some other monetary policy solution, rather than intervention. G7 starts its preliminary meetings this month ahead of the summit in late May—in Japan.

We guess G7 is pressuring Japan to avoid intervention and to get a currency effect through other means because this is what it is telling China. What kind of lesson does it send to China if it “permits” Japan to intervene in FX while frowning on China doing the same thing? Hypocrisy, thy name is The West. But honestly, this is a false equivalency. If the WSJ is right, what is moving the dollar/yen now is authentic investors departing the Nikkei and taking their yen short hedges with them, automatically and mechanically driving the yen higher. Unless Japan were to impose capital controls—unheard of for developed countries—Japan is supposed to suck it up and let the process run its course.

The only possible justification Japan would have to intervene would be to name the move “disorderly” while at the same time insisting the BoJ does not target the exchange rate. We could also get jawboning instead of outright cash intervention, and that could include rhetoric on more rate cuts. It won’t be long before somebody mentions that negative rates and persistent intervention didn’t help Switzerland all that much or all that long. But this time it’s the stock market, not trade, behind the currency move. Market News cites Capital Economics naming “’three prior instances in the past 20 years when the yen rose "substantially in response to a large increase in stock market volatility," i.e. 1) the fall of 1998, a time of a Russian ruble crisis and hedge fund LTCM's collapse, 2) the summer of 2002 "towards the tail end of the multi-year correction that followed the bursting of the U.S. dotcom bubble" and 3) during the "run-up to the last financial crisis.’ The yen rebounds seen on those occasions were larger than recent gains, with carry trade unwinds at the time a key reason for this, he said.”

This time it’s not carry trade unwinding per se behind the yen’s rise. In fact, with everybody’s rates at or near zero, the carry trade has gone out of fashion. Once this current equity selling is over with, the carry trade doesn’t present a new threat, and Capital Economics is sticking to its forecast of the dollar/yen at year-end at 130. JP Morgan has a forecast of 110 for Q4. We do not agree. A swift turnaround in dollar/yen is not consistent with historical precedent. Having said that, we never had negative returns before, either.

Nobody knows where this one is going to go or when it’s going to end. One thing we know is that central banks believe themselves ill-equipped to manage a global commodity and stock market meltdown that has undertones and overtones of currency distress. Central banks are not in charge of the oil price and in fact try their darnedest to avoid any and all commodity prices. With even greater specific revulsion, central banks try to avoid involvement in currency markets, not least because it so often comes back to bite them on the rear-end. It’s one thing for the Australian PM or finance minister to complain about the exchange rate and something else entirely when it’s the BoJ or (heaven forbid) the Fed.

What central banks can do in situations like this is twist arms behind the scenes and tacitly egg on bottom fishers. But most central bankers honestly do believe “let the market decide” is the best policy. They know full well that interfering with market mechanisms results in misallocations and any number of distortions, many of them unknown unknowns. At a guess, central banks are going to go dark for at least a few days.

Why all this is dollar-negative is a mystery. Honest. Logically, even if global investors are going to cash, they should prefer the currency that has some return, not the euro that has none or a cost instead of a return. But the trend is our friend, so we are stuck with more of the same in the major currencies unless and until Something Happens. Let’s just hope it’s not only China.