Shortly before the international market collapse, a group of elite American financiers convened for a summer luncheon. They engaged in casual discussions about financial forecasts – with the consensus being relatively insipid. Most predicted a ‘soft landing’ for the American economy, with 3-3.5% rates in 12 months and a 10% shift in shares, with an even distribution of increase and decrease.
The only truly intriguing detail was the shift in their perception of the American electoral race. Three weeks prior, it was commonly held that Donald Trump would be victorious. However, this luncheon deemed it a fifty-fifty race. Nobody predicted a market disaster on the horizon.
There are a couple of significant takeaways from this. Firstly, even the most accomplished financiers, including hedge fund managers, private equity practitioners, or banking professionals, find it challenging to predict exact market crash timings with clarity. Although it’s possible to pinpoint potential pressure points and vulnerabilities, determining when these will lead to a market tumble is as complex as authentic geology. This unpredictability necessitates a level of humility – more so considering the enhanced price instability and feedback cycles resulting from the rise in algorithmic trade.
Secondly, the market turmoil was more influenced by financial dynamics than fears about the ‘real economy’. As expressed in a letter to clients by Bridgewater: “We see the prevalent deleveraging decidedly as a market event rather than an economic one,” since “times of structurally low instability have consistently set the stage for excessive positioning,” which will inevitably be rectified.
Alternatively stated, these incidents may be seen as another repercussion of the unwinding of the unprecedented monetary policy experiment – known as quantitative easing and zero interest rates. Investors have become so acclimated to inexpensive money that they hardly acknowledge how much it has warped the market, but they are now gradually recognising this peculiarity. Therefore, these crises have been significantly enlightening despite the intensified drama due to electronic trading.
The yen carry trade phenomenon, where bargain yen loans are utilised to purchase higher-yield assets such as US technology stocks, is an immediate manifestation of this. With the Bank of Japan’s commencement of Quantitative Easing (QE) in the latter part of the 1990s, affordable yen loans have consistently propelled global finances, though the magnitude has oscillated depending on US and European rates.
The carry trade, however, seemed to surge after 2021 came to a close when the US shifted its policy away from QE and zero-rate interest. The Bank of Japan’s long-awaited tightening earlier this year saw the paradigm fade. The extent of this transformation is uncertain. The Bank for International Settlements indicates that cross-border yen borrowing has elevated by $742 billion post-late 2021, and banks like UBS approximate a gross carry trade of around $500 billion earlier this year. UBS and JPMorgan predict that approximately fifty percent of these trades have been unwound.
However, experts have opposing views on the extent to which these trades helped inflate US tech stocks, thereby accounting for the recent downfall. Both JPMorgan and UBS believe it played a role, whereas Charlie McElligott, a strategist with Nomura, considers the carry trade to be a diversion. He, along with other observers, opines that concerns of an overhyped US tech sector led to a decrease in yen financing, not vice versa. Regardless, the crucial point is that the era of quasi-free money, which was inflating assets in America and Japan, is reaching its end.
Notably, this has prompted certain investors to search for other long-neglected QE distortions that might also unwind. This week, a few readers enquired if there would be yet another jolt when the Bank of Japan or the Swiss National Bank decide to wrap up the equity portfolios they amassed over recent years. In answer, that time is not now, despite these holdings appearing bizarre by historical precedents, as the Bank of Japan is firm it isn’t going to offload any time soon. Intriguingly, this issue is beginning to garner attention from non-Japanese investors, who have been normalising it for many years.
US Treasury bonds too are on the radar. Despite the decay in America’s fiscal health and ambiguous electoral policy, numerous investors believe these will continually see high demand since the dollar is a reserve currency. Only time will tell.
The Federal Reserve’s role as the ultimate purchaser of bonds during quantitative easing has fortified an environment of either confidence or overconfidence. With traders now envisioning a reality where this role shifts, apprehensive feelings are emerging. This was evidenced by the surprisingly weak outcome of a 10-year bond auction this week, which was worth $42 billion.
Sceptics may argue this mental recalibration could be unwarranted; they believe market turbulence would force central banks to once again intervene. A demonstration of this was the Bank of Japan (BoJ) deputy governor promising to retain the existing monetary easing measures on Wednesday, defying earlier suggestions of potential rate hikes by the BoJ governor.
Nevertheless, the main takeaway is the non-normalcy of the abundant availability of complimentary money. The quicker investors comprehend this, preferably sooner, the more beneficial it will be, irrespective of whether they are everyday savers, private equity stalwarts, hedge fund operators, or central bankers themselves. – Copyright The Financial Times Limited 2024.