I think we should pause for a moment, and send good thoughts and positive energy to Bank of Japan (BOJ) Governor, Haruhiko Kuroda. He needs them; Mr. Kuroda is having a miserable time. Here’s a guy who practically had a gun to his head to “encourage” him to initiate Negative Interest Rate Policy (NIRP) in a desperate attempt to combat deflation. Mr. Kuroda reluctantly enacts NIRP, and the value of his currency goes up, by a lot. Currency up, prices down—the opposite of what everyone in the country wanted.
All Governor Kuroda has received for his efforts is a group of angry and harmed banks. They can’t pass these negative rates on to customers because if they charge depositors to keep their money in the bank, depositors will turn to the “Bank of Mattress.” Additionally, if the banks try to pass the charge on to borrowers by increasing lending rates, it won’t work because no one they want to lend to is borrowing to begin with. Since banks are the main transmission vehicle for monetary policy, hurting them really wasn’t part of the plan.
Moreover, now that the BOJ has gone down the road of NIRP, the old adage, “In for a penny, in for a pound,” has taken over. The BOJ started NIRP in January, and things have just gotten worse. Governor Kuroda is currently under pressure to make the BOJ policy rate more negative during this month’s meeting or the next one in June (or both). I don’t think even the wackiest academic ever thought of NIRP as a long-term policy. Rather, I think it was viewed as monetary defibrillation—a shock to get the heart going again. But, what we have now in Japan and Europe, is a plan that wakes up the patient once a night and zaps him with the paddles for weeks on end.
So why is the Yen rallying at a time that seems counterintuitive?
The Yen is a safe-haven currency. In the last two major financial crises (1998 and 2008), the Yen appreciated against the U.S. Dollar (USD) by 23% and 21% respectively. What makes that more impressive is that during those times, the USD rallied against every other currency except the Swiss Franc.
While it may seem odd that panicked investors would flock to the Yen as opposed to the USD, remember the USD is already the ultimate safe-haven, reserve currency. The money is already here—both in good times and bad. However, in times of extreme distress, funds can’t all be in USD. So when those great investments in South African Rand go belly-up, the flows move to the Yen. Despite the rebound in stocks over the past 45 days or so, risk profiles of global investors have been declining as many view the latest rally as a bear-market, short-covering event. Hence, the bid for the Yen.
Japanese interest rates have been among the lowest in the world since 1990, and because the Yen is a highly liquid currency, when hedge funds make their bets, they fund themselves by borrowing Yen (which is akin to shorting it) and investing in a higher yielding asset, in a higher yielding currency. This is the famous “Yen Carry Trade” that probably sustained most hedge funds’ “Alpha” for many years. Hedge funds leverage themselves up with borrowed Yen and invest in whatever happens to be the flavor of the season. Therefore, when things get ugly (like in 1998 or 2008), trades get unwound, and hedge funds have to buy back all that borrowed Yen to close out their trades. Some of this is happening now.
As Japanese Government Bonds (JGBs) have gone to negative yields (thanks to the BOJ’s Quantitative Easing policy), Japanese Banks have bought significant amounts of U.S. Treasury notes and bonds. This equates to a Long-USD/Short-Yen position, as it is believed that a good amount of this flow was not swapped back into Yen (meaning, the banks took currency risk). Once the Yen began rallying, banks have been furiously buying back Yen to close out the currency risk. A classic short squeeze.
Therefore, despite possessing near zero interest rates, the Yen has appreciated nearly 14% against the USD in the past two weeks. Japanese officials will—as they did Thursday night—attempt to talk the currency lower, but with the G-7 meeting coming to Japan next week, the Japanese won’t intervene by selling Yen to weaken the currency.
Following the Yen right now is an important gauge for true risk appetite, and the gauge is turning negative. Equities and investment-grade corporates have had a great run since the middle of February, but I think it’s time to take winnings off the table. With regard to rates, we made a good call on buying the belly of the curve (5-year and 7-year) a couple of weeks ago; however, I think that trade has run its course. Unless the Federal Reserve starts cutting rates, I can’t see the 5-year getting much past 1.15% (1.17% this morning). Last week, we recommended the long end of the municipal curve, and that has turned out well. This past week, the 2046 point of the curve tightened versus treasuries’ 14 basis points. That is on top of the 30-year Treasury bond decreasing nine basis points in yield. I still like that trade.
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