In a Handbasket

The Yen Carry Trade and the Coming Recession

Imagine you’re at a casino, and suddenly, the house changes the rules of the game in the middle of a hand of cards. On July 31st, the Bank of Japan (BoJ) reversed 25 years of economic policy and unexpectedly raised interest rates by 0.25%, even though everyone expected only a small change. This move, combined with some really combative words from the Bank’s Governor Ueda, caught everyone off guard and as a result, the Japanese yen, Japan’s currency, jumped in value from 154 yen per dollar to about 150-151 yen per dollar.

Um, so? What does that have to do with anything?

A lot, it seems. See, what you and I don’t know is that there is something that has developed over the past 20 years called the Yen Carry Trade. It’s sort of always been a thing where hedge funds can borrow money in Yen and pay some fees but no interest on the money. They turn around and invest that borrowed money in currencies where they can earn higher interest. In effect, it’s free money, and the only risk is some small fluctuations in the value of the Yen.

Carry trades are like borrowing chips at a low cost from one casino table and betting them at another table with higher stakes to make a profit. Traders do this with currencies, borrowing yen because it’s cheap and investing in dollars that offer better returns. Japan’s very low interest rates made it an attractive option for these traders, turning it into a massive market, with Deutsche Bank analysts estimating it at $20 trillion USD equivalent.

To bring it to a level I can understand: Borrow one million dollars worth of Yen at zero interest and invest that money in US bonds paying 4.75% and you make $47,500 per year virtually risk free - that’s the game. Last week $1m converted into yen would get you a loan of 154m Yen — you owe that to the bank that loaned you the money. A week later, the same $1m you converted into yen will only buy you 150m yen, leaving you short 4m yen, or ~$29k, when you convert the dollars back to yen to make your payment. Your $47,500 return just became ~$18,500 before you pay fees, etc. A 2.6% move in the value of the yen just cost you half of your return — in what was supposed to a sure bet. Now multiply that by 20 billion times to understand the size of the panic.

Well, but you and I don’t trade in such risky things like currency speculation, right? Not directly, no, but every financial institution on earth has some exposure to the cross border carry trade. It’s a way that they make money on assets that are often described as risk-free.

When it comes time to pay up, these institutions are holding a losing hand of cards — or at least a card that isn’t as strong as they thought — and they start scrambling to fold them early, cut their losses, and buy back in later. Because traders get paid to trade, the firms know that if they are taking a hit on these investments so are their competitors and so they start selling their competitors short. When stocks move, the algorithms start trading, too, and the tidal wave of sell-offs washed away $650b in paper shareholder value on the NASDAQ alone. The NYSE lost $741b in paper value. All around the world, markets have lost $2.47 trillion in value … because of an increase in interest rates of .0025 in Japan.

Are you catching that? If you had $100 worth of yen on deposit in a savings account in Japan, you’d earn a quarter — five nickels! — in interest per year. Changing that number from zero to something so minuscule just wiped out the equivalent of the entire economy of Russia in GDP terms. And you had no idea it was even a thing!

But the BoJ knew. In July alone, Japan’s government spent around $36 billion trying to keep the yen from losing value. They did this because the BoJ is stuck in something called the Impossible Trilemma where you try to keep enough cash in circulation for daily living, have fixed interest rates over the long term so businesses have certainty around investing, and keeping monetary policy independent of government action. People say it’s like trying to run a casino that’s always full, has free drinks all night, and always has players winning big jackpots. You can’t do all three at once; you have to pick two. Japan has been trying to balance these three goals, but it’s incredibly tough.

The BoJ’s surprise rate hike and their ongoing efforts to support the yen highlight the complexities of managing a country’s economy. Governor Ueda’s bold actions are shaking things up, and Japan is facing significant changes as they navigate these financial challenges.

“If it weren’t for bad luck, I’d have no luck at all."

— Albert King

None of this would matter if it came at almost any time, but right now the US and therefore the world, is flirting dangerously with an overdue recession.

The signs are all there: GDP growth is limping along like a geriatric tortoise. We’re seeing retail sales flatten out and personal savings dwindle as households grapple with the twin spectres of inflation and rising interest rates. When consumers start tightening their belts, it’s often a harbinger of rough seas ahead.

And make no mistake, we are seeing the US middle class consumer struggling.

Inflation isn't just high; it's soaring like Icarus on a bender. The Federal Reserve, in its infinite wisdom, has responded with aggressive rate hikes, cranking up the cost of borrowing — too much and too fast and then has insanely denied that inflation existed at all, and then even more stupidly has decided that inflation isn’t a compound effect. This isn't just a bump in the road—it’s a potential head-on collision with economic activity. Higher interest rates make it more expensive to buy homes, cars, and finance business expansions. Historically, the entire point of monetary tightening causes recessions where the business cycle can cool and rest.

Yes, the labor market has been resilient, people can find jobs if they want them — and at crazy higher wages than just 3-4 years ago — but the cracks are starting to show. Job growth is slowing, and initial claims for unemployment benefits are ticking up. If businesses get spooked by weakening demand, they’ll start cutting jobs, and higher unemployment rates will follow. This, in turn, puts a dent in consumer confidence and spending, further stalling the economic engine.

Corporate earnings are a mixed bag, with many companies sounding the alarm about rising costs and economic uncertainties. Business investment is also on the back foot—companies are wary of expanding or starting new projects when financing costs are climbing and the economic outlook is cloudy. And where are they investing? In AI and things that do more with less people, and therefore less wages, which is what power the American consumer class. Reduced business investment means slower economic growth, setting the stage for a recession.

The global backdrop is far from rosy. Major economies like China and the Eurozone are wrestling with their own demons, and this global instability can ripple through to the US. Trade disruptions, geopolitical tensions (hello, Ukraine. hello Iran. hello, Taiwan), and supply chain snafus all contribute to a precarious global economic environment. A downturn in global growth can dampen demand for US exports, adding to the domestic economic woes.

High levels of corporate and household debt are a ticking time bomb — especially in commercial real estate. Rising interest rates increase the cost of servicing this debt, stretching finances to the breaking point and raising the specter of defaults. A beautiful new skyscraper in Atlanta just sold for 43% less than its previous sale. The financial instability in debt-heavy sectors like real estate or corporate bonds could trigger a broader economic crisis. A significant market correction or financial shock could have cascading effects, choking off investment and spending.

Let’s not forget the psychological component. Consumer and business sentiment surveys are flashing red. When confidence in the future takes a nosedive, spending and investment follow suit, deepening the economic malaise and nudging us closer to recession territory.

You know I’ve been looking for this recession for awhile. I think we entered technical inflation early last year although Biden’s economic advisors denied it saying “we decide when we are in recession.” Ok, Boomer.

The US economy is teetering on the edge. Slowing GDP growth, relentless inflation, rising interest rates, labor market pressures, shaky corporate earnings, global economic uncertainty, towering debt levels, and plummeting sentiment all combine to paint a pretty grim picture. It’s a stew of economic strife that policymakers, businesses, and consumers must navigate with caution to stave off the looming recession.

The recession will reprice the equity markets for the next 15 years. And I’m waiting over here with a mountain of cash ready to wade in and buy things at more than a 20% discount to current prices.

You should be, too.