Introduction

I have been wondering why JPY has been falling so sharply. One potential explanation ¬is that there is a new JPY carry trade. This might also explain why global equities have been so strong recently.

Evidence For a New Carry Trade

The evidence for the idea of a new carry trade comes in two forms.
First, the behaviour of global asset prices is suggestive of a liquidity-driven rally. Global equities have risen sharply since mid-December (when the LDP was elected) in a correlated fashion, and all major currencies have risen against JPY.

Second, the behaviour of JPY is not explicable in terms of its usual relationships. For the past several years, USD/JPY has been extremely closely related to the two-year interest rate differential. That relationship has now snapped, sharply. An obvious explanation for this is that capital has flowed out of Japan.

Evidence Against a New Carry Trade

The evidence against a new carry trade also comes in two forms.
First, not all asset prices have increased. In particular, corporate bond yields have increased since mid-December. Spreads may be a better measure of liquidity-driven flows, but while they contracted in December, they then plateaued and have recently started widening. Meanwhile, JPY has continued to weaken.

Second, the strength of the US equity market, at least, can be explained in other ways. The level of US equities since June 2009 (which I take as being the moment of market normalisation) has been closely related to funding conditions, and in particular the 2-year real interest rate (2-year government bond minus 2-year inflation swap). This rate has fallen in the past month as economic expectations have improved, driving up expected inflation, and US equities have risen as the model would have predicted.

Discussion

The first objection to the idea of a new carry trade is not necessarily convincing. In the previous JPY-carry-trade period in the mid-2000’s, US credit spreads got low and stayed low – they did not fall continuously through the mid-2000’s. The fact that credit spreads are not narrowing today is therefore not a strong objection, especially as they are at post-crisis lows.

The second objection has some merit, but it is not entirely consistent. US funding conditions have tended to determine global equity market flows as well as domestic flows, as shown by the fact that USD has tended to fall against local currencies when local equities have rallied. In the recent market rally, USD has risen against AUD, TWD, KRW and SGD as their equity markets have rallied. If these equity markets have been driven by international liquidity flows then they have not come from USD.

Further, US equities have, over the longer term and in recent years, also been closely related to a simple combination of trailing earnings and credit spreads. This model makes some theoretical sense: it sees the value of a stock as being a function of expected future earnings, which are themselves a function of current earnings and a risk factor that would be something like a credit spread. In the past month, equities have run up much more strongly than this model would have suggested.

In summary, then, the objections to the idea of a new JPY carry trade are not decisive, and the movements of asset prices over the past month suggest that global markets have been driven by liquidity flows out of JPY.

Further Evidence

Data on the assets of Japanese banks suggest that they reduced their holdings of domestic government bonds throughout 2012. Further, the data show that Japanese banks sharply increased their holdings of foreign assets in the first three months of 2012 (after the BoJ adopted its inflation “goal”) and again from August 2012 (as political consensus on a change at the BoJ began to grow). However, the levels of “Investment Securities of which Foreign Assets” and “Foreign Securities Held for Investment Trusts” – measures of foreign assets held by the public, I think – did not jump in the same way. Both grew pretty consistently during the previous carry-trade period in the mid-2000’s. If banks have increased their rate of acquisition of foreign securities still further, or if investors have increased their exposures, then that should be clear from these data series when the January numbers are released. That will happen on 1st March.

What Would be the Implications of a New JPY Carry Trade?

In the previous carry-trade period, Japan had the lowest interest rates in the world. It was therefore a provider of liquidity to the world. For the past few years, however, the US has had very low interest rates as well.

This means that international investors already have all the cheap liquidity they want. Therefore, it would not be reasonable to expect a change in the behaviour of global markets in general on account of a change in the behaviour of international investors. If a new JPY carry trade is driving up asset prices around the world at present, it must be because JPY-based investors have taken the election of the new government as a sign that it is safe to transfer a significant portion of their assets abroad. That should cause a liquidity-driven rally in markets, but unless the reactions of Japanese investors to news- and data-flow are markedly different from those of their foreign counterparts, it should not mean a permanent break in the relationships between asset prices and other variables that have obtained since June 2009.

Conclusions

  1. The evidence suggests that a new JPY carry trade is a distinct possibility.
  2. If there is a new JPY carry trade, then it ought to be a phenomenon with a finite life, as Japanese investors carry out a one-off reallocation to global assets.
  3. Once this reallocation is over, JPY ought to stabilise.
  4. Because this process may be occurring, it will be dangerous to short global risk assets until JPY has stabilised.
  5. Once JPY has stabilised, it should be possible to trade global markets on the basis of their normal behaviour over the past few years.
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