Japan's 586 Trillion Yen Arbitrage Harvest

The past week on Wall Street has been a rollercoaster, especially "Black Monday" (August 5, 2024), which caught most investors and even professionals off guard.

One of the reasons is the collapse of the "yen carry trade," which reportedly involved about $4 trillion (approximately 586 trillion yen) of highly leveraged funds with a leverage ratio of 300:1.

Despite the U.S. stock market showing signs of recovery after the plunge, this minor collapse is widely believed to be caused by the Bank of Japan's sudden tightening of monetary policy, attempting to create a "yen carry trade" to harvest global interest rate differentials, including the U.S. market, which is a symbolic black swan event.

As the Bank of Japan and the Ministry of Finance tried to pull the yen out of its increasingly severe plunge, the long-term foreign exchange strategy suddenly turned into a disaster.

So, what is the logic behind this harvest?

First, the "yen carry trade" is a simple strategy: borrowing from countries with lower interest rates (such as Japan or Switzerland) and then investing in currencies with higher interest rates (such as the U.S. dollar).

If everything goes well, the result is a cost-free profit.

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Not surprisingly, this strategy is popular among financial traders, corporations, and even individuals who use it to pay for mortgages in their home country.

At the current level, global investors can borrow yen at an interest rate of about 0.5% and find safe U.S. investments at an interest rate of about 5.5%.

This means a 4% gain without investment.

The only potential problem is that the exchange rate between the two countries begins to change.

In this case, a strong yen means you need more dollars to repay the loan, which can offset the gains and lead to increased losses.

Derivatives trader Ichiro Sekimitsu said, "When participants in the 'crowded trade' (yen carry trade) all try to exit at the same time, the market will experience violent fluctuations.

Downward fluctuations can be rapid and severe, sometimes leading to changes in market psychology," "The necessary condition for the continuation of trading is low volatility, so a series of signals from the Bank of Japan and the Ministry of Finance, as well as poor economic performance in Japan, may help to establish this trade."

However, on "Black Monday" on August 5th, the yen appreciated rapidly, and the stock market fell, causing all of this to turn into nothingness, which in turn triggered a larger scale of closing positions of the so-called "yen bears," that is, betting that the yen will fall further.

This led to a sharp appreciation of the yen, and traders quickly closed positions.

It should be noted that in mid-July, 1 U.S. dollar was worth 161 yen, but by the end of the Asian trading day on August 5th, 1 U.S. dollar was worth 142 yen, a 12% devaluation.

This would easily wipe out a year's interest expenditure on yen carry trade.

Subsequently, a tragic retreat and run ensued.

Second, the catalyst was the Bank of Japan's (BOJ) sudden tightening of monetary policy a week ago on July 31st.

The BOJ adopted a dual strategy, on the one hand, raising the target interest rate for Japanese government bonds, and on the other hand, announcing a significant reduction in bond purchases, as a measure to control interest rates, catching the market off guard.

However, the new target interest rate for 10-year Japanese government bonds is still only 0.25%, although higher than the previous 0-0.10%, but it is insignificant compared to the current 4% interest rate on U.S. Treasury bonds.

But this move by the Bank of Japan is of great significance, breaking the loose monetary policy that has been in place for ten years.

Due to Japan's long-term super loose, even nearly negative interest rate environment, the country's current inflation problem has emerged, and the yen's previous excessive and significant depreciation has clearly pushed up the inflation rate, reducing the purchasing power of Japanese consumers.

In response, BOJ Governor Haruhiko Kuroda made tough remarks on interest rate changes in July and indeed raised interest rates suddenly at the end of the month.

Although Japan's core consumer price index is 2.6%, it seems far from a crisis.

However, the impact on ordinary Japanese people is obvious, with Japan's inflation rate exceeding income for 26 out of the past 27 months.

A country that has long pursued inflation does not like inflation in practice, and increasingly worried Japanese officials have been putting pressure on the Bank of Japan to take action.

Another deep-seated reason behind this is that since Japan relies heavily on imports for almost all of its energy and most of its food, rising import costs will directly affect Japan's real economy and consumer spending.

Third, the concern of Japanese consumers about rising prices is considered a key factor leading to the low approval rating of about 25% for Prime Minister Fumio Kishida's government.

Kishida must run for re-election in September to maintain the ruling Liberal Democratic Party's presidency, which makes the inflation dilemma more prominent.

If he loses, he will automatically resign as prime minister.

This seems to explain that, according to data from Japanese monetary authorities, Japan has tried to intervene massively in the foreign exchange market to curb the yen's depreciation.

On April 29th alone, Japan set a record by purchasing 5.92 trillion yen (about $36.9 billion at the time), and made a smaller purchase on May 1st.

However, if the Bank of Japan's actions are strong, the impact on the Japanese stock market is also huge.

The Japanese stock market only took 34 years to break through the previous high.

However, the recent Nikkei 225 stock index plummeted by 12%, the second-largest percentage drop in history, falling 27% from the highest point on July 11th.

Fourth, as this panic spreads, coupled with a series of warnings about market crashes, the decline in the Tokyo stock market has triggered a series of negative storms, including the weak U.S. employment report and the news that Warren Buffett sold most of his shares in Apple.

Although the U.S. stock market did not fall much that day, the Dow Jones Industrial Average closed down by 2.6%, but pessimism prevailed.

Most positions were closed within 24 hours, a fact that shows the fragility of the sell-off.

Tokyo traders thought they were completely wrong and continued to push the Nikkei index up by 10.2%, the fourth-largest single-day gain in history.

By Wednesday, the Japanese stock market rose again, with the Nikkei index up by 1.2%, and the yen gave up most of its gains.

Previously, Bank of Japan Deputy Governor Naoki Tsuchiya tried to curb the rise in the stock market, saying that the central bank would not raise interest rates further if the market was turbulent.

Although his remarks were seen as temporarily calming the market, this stopgap measure is likely to have an impact in the future.

His remarks seem to contradict Governor Haruhiko Kuroda's commitment to raising interest rates if necessary a week ago, and these remarks seem to be a panic response, or a signal of disagreement within the Bank of Japan's top echelons.

Executive Economist Takayuki Kishimoto of the Nomura Research Institute said, "This way of communication has damaged the credibility of the Bank of Japan.

For the financial market, the uncertainty of future monetary policy has increased."

"Naoki said too much, and the Bank of Japan's current communication strategy is problematic."

So does this mean that Japan will stop this "carry trade" harvest model?

Most analysts say that the market turmoil is far from over, and data from the U.S. Commodity Futures Trading Commission show that the total value of speculative yen short positions has fallen from $14.5 billion at the beginning of July to the latest $6 billion, indicating that there is still more to do if the yen strengthens again.

Kishimoto predicted that within the next three years, the yen's exchange rate against the U.S. dollar will return to a "reasonable level" of about 115 yen.

He said, "The adjustment phase is still in the middle stage, depending on the situation of the U.S. economy.

But this is just a crisis in Japan, not a crisis in the global stock market."

But for those engaged in yen carry trade, this means there is still a long way to go, and there may be more fluctuations in the future.

In this regard, Dohmen Capital Research analyzed on August 10th that the bear market on Wall Street is coming.

It is expected that there will still be a lot of selling in the coming weeks and months.

At the same time, JPMorgan Chase released a report on stock rotation, the Japanese market, and carry trade closing on August 9th, stating that the Wall Street market is no longer a one-way rise, but more and more centered on economic downturn risks, Fed policy timing, crowded positions, high valuations, and increasing election and geopolitical uncertainties.

The focus in the second half of the year is rapidly shifting to growth risks... What is more noteworthy than the Japanese Kishida authorities facing a reshuffling and indirectly promoting the Bank of Japan to create the above harvest event is that as the U.S. election storm becomes increasingly fierce, the strategies of both Trump and Harris teams are currently approaching the stage of showing their cards.

The former has made it clear that he will intervene and even change the Fed, while the latter is trying to maintain the Fed's independent operation model.

This means that there are still various variables in the Fed's true interest rate cuts.

This has also become a bigger black swan event after Japan's harvest of the U.S. market.

As Trump recently opposed the Fed's interest rate cut before November, calling the Fed's decision a gift to the Democratic Party.

In addition, he also commented on the sharp drop in U.S. stocks last week, calling it the "Kamala Crash" (Kamala refers to Kamala Harris).

He also wrote on social media: "Trump-Cash VS Kamala-Crash!"

(TRUMP CASH VS KAMALA CRASH).

Not only that, Trump also claimed at a rally in Atlanta, Georgia, that if Harris is elected, she will "destroy" the U.S. economy, citing the recent rise in U.S. unemployment to 4.3%.

He also warned last week that the U.S. economy is about to stage the Great Depression of the 1930s.Here is the translation of the provided content into English: Some analyses suggest that this could also be one of the reasons why Buffett, after nearly an 800% return on his investment, appears to be "dumping Apple" and signaling an early retreat.