August 2, 2024
By Steve Blumenthal

The Sahm Rule triggered the recession call today. The (data) shows that the +80 bp jump in the jobless rate over the past year is a 100% iron-clad indicator that the downturn has either arrived or is about to. The Fed is as behind the economic curve now as it was behind the inflation curve back in 2021-2022. Most of this tightening phase and cyclical bear market in bonds is set to unwind in dramatic fashion.

– David Rosenberg, @EconGuyRosie

Imagine you could go to your bank and borrow money at an interest rate close to 0%, then take the borrowed money and invest it in a bond earning 5%. Borrow a million dollars worth and make $50,000. Borrowing means leverage, and leverage can work, but there are risks. That is the story of the Japanese Yen carry trade I want to tell you today.

A few years ago, I was looking to leverage the gains on my home by taking out a second mortgage and reinvesting the borrowed money in a private credit fund. Borrow at 3% and invest at 10%, making a spread of 7% or translated into actual dollars, earning a net $70,000 a year on a $1 million dollar loan. I assessed the risks and liked the play. Unfortunately, I was asleep at the switch. A quick five Fed rate hikes from 0.50% to 5% put my play on hold. I’m hoping to see mortgage rates in the 5% range giving me another shot at the trade. 

Millions of people, institutions, and fund managers have been making decisions like this for years. 

The global go-to place to borrow is Japan where interest rates have been near 0% for a very long time. Investors from another country can borrow money from Japan at 0% and reinvest it at a higher rate somewhere else. It is known as a “carry trade,” and it doesn’t come without risk. The risks are generally fourfold: One, a U.S. investor borrows in the Yen, so there is a currency risk that should be hedged because the dollar, and the Yen don’t move in sync. Second, there is interest rate risk. Both currencies and bond prices can go up or down based on the movement of interest rates. Third, there is risk in the asset of choice the investor chooses to allocate the borrowed capital (i.e., corporate bonds, stocks, long-duration Treasury bonds, private credit funds, equities). Fourth, there is counter-party risk, in this case, the Japanese government and the investor’s brokerage custodian. The Japanese may be a lesser risk than Lehman Brothers in 2008, but who could have imagined Lehman going out of business? 

Leverage is great until it isn’t, and it is always leverage that blows things up. You’ll recall the Nobel prize geniuses who blew up Long Term Capital Management in 1998 and the leverage tied to the subprime mortgage derivative investments that led to the Great Financial Crisis in 2008. All that leverage created a wild frenzy in the housing market until the bubble popped. The fallout rippled globally and nearly collapsed the financial system until the U.S. government came in to save the day. It was excessive leverage at the top of the tech bubble in 2000. 

One of the “leverage” risks I’ve been watching for a long time is the Yen carry trade. I write frequently about the size of the U.S. debt and entitlement system. I think it is the big elephant in the room, but something else might light the fuse. One of the glaring risks out there is the yen carry trade. My friend John Mauldin wrote about it in 2014, and he put his money where his mouth is. He essentially paid a fixed amount of money placing a trade with a big Wall Street investment bank. He essentially bought a put option that would make him money if the yen declined. If it did, the gain on his bet would pay off his entire U.S. mortgage. If not, he’d risk a defined amount of money that he was willing to lose, and given how low U.S. mortgage rates were back then (remember zero interest rate policy), the interest cost on his mortgage was so low he had some risk capital to work with.

In May 2014, he wrote a piece titled “A Yen for a Mortgage.” Think about it this way: if you borrow $1 million in a foreign currency, in this case, the Yen, and invest the money in a U.S. asset priced in dollars, if the Yen goes down 20% vs. the value of the dollar, and you decide to pay off the loan, your net effective loan payoff, in dollar terms, is $800,000. That is what matters to your bottom line when you convert your dollars back into Yen.

In terms of the carry trade, investors borrow from Japan at a low rate and invest somewhere else at a higher rate, thus earning the spread less the cost of their hedges. 

Anyone who has traveled overseas knows the benefit of a higher-valued dollar vs. a lower-valued foreign currency. Or the reverse, depending on where you travel. Smart travelers see this and use it to their advantage. 

Back then, John called the Japanese Yen “a bug in search of a windshield.” The problem is that that pesky bug has done a great job avoiding the windshield for the last ten years. His bet was on a declining Yen vs. the U.S. dollar, which would essentially pay off his mortgage loan if he was correct. He used a synthetic trade, buying 10-year put options from a large U.S. bank. John ended up closing out his trade for a loss. We talked about it back then. It was worth the bet. I’m not sure he’s up for another 10-year synthetic put option, but the bug/windshield trade still makes sense today.

What I’m getting at is that there is no free lunch, and one of the biggest risks in the system is the potential unwinding of the Yen Carry Trade. Will the bug hit the windshield? The odds are well north of zero.

My current concern is the massive size of the leverage in the yen carry trade.

Deutsche Bank analysts warn that the Japanese government is engaged in a massive $20 trillion “carry trade”—the funding of loans and foreign assets by borrowing low-cost yen—that could bring unexpected risks if the central bank tightens policy.

Tightening policy means higher interest rates. Take a look at the following chart from the St. Louis Fed and focus on the last 30 years. That flat line is what free money looks like. Tightening policy means the flat line on the bottom right side of the chart will begin to rise. 

Sources: Noted in the chart above. Here’s the Fed website (note disclosures). 

Using research by the San Francisco Federal Reserve and International Monetary Fund, Deutsche’s head of currency research, George Saravelos, analyzed the Japanese government’s consolidated balance sheet, including the government-run pension fund GPIF, the Bank of Japan (BOJ), and state-owned banks, and estimated the total amount of carry trade debt to be $20 trillion.

In comparison, back of the napkin, the total size of the U.S. public equity market is ~ $50 trillion, the total size of the global stock markets is ~ $110 trillion, and the total value of U.S. residential real estate is ~ $50 trillion.

$20 trillion is a lot of leverage.

What could go wrong? 

Well, the bug may finally smash into the windshield. 

Here is a bit more education on the carry trade: The carry trade is a trading strategy that involves borrowing money in a low-interest-rate currency and using that money to invest in higher-yielding assets denominated in another currency. The goal is to profit from the interest rate differential between the two currencies. For example, an investor could borrow money in the Japanese yen, which has had very low interest rates for years, and use that money to invest in U.S. Treasuries or other higher-yielding assets denominated in U.S. dollars. A non-U.S. investor could do the same thing. As long as the yen does not appreciate significantly against the dollar (or currency in play), the investor can pocket the difference in interest rate spread as a profit. The carry trade allows investors to essentially get “free money” by borrowing at low rates and investing at higher rates. However, it also carries significant risks, especially if the low-interest currency appreciates against the higher-yielding currency, which can lead to losses. Nothing is ever free.

That decrease in the purchasing power of the Yen vs. USD has essentially started in 2021. It was 103 per 1 USD in January 2021, roughly the high over the prior ten years. The Yen declined in value to a 34-year low against the dollar on June 27, 2024, at 160.49 Yen per 1 USD. The yen has been moving higher since closing at 150.76 per 1 USD yesterday, August 1, 2024. Note, I know this is confusing as we are viewing yen to the dollar, so if the price of yen to the dollar, like in the above example, goes down, it is an improvement in the value of yen vs. the dollar. Thus, a drop in the ratio is a move up in yen. The opposite is also true. 

Timing the potential unwinding of the carry trade is not easy, as governments can kick cans down roads longer than anyone may know. But since 2021, a shift appears to be afoot. 

The point I want to make is that the carry trade poses a significant risk to global markets, and we may be nearing the “bug hits windshield” point in the $20 trillion leveraged trade:

• Japan has had extremely low interest rates for over twenty years, enabling a massive $20 trillion carry trade in which investors borrow at low interest rates priced in yen to invest in higher-yielding assets in other parts of the world. The trade is great when the currency exchange rates are relative level. 
• However, Japan is heavily reliant on imported oil, which is priced in US dollars. As the yen weakens against the dollar, the cost of oil imports in yen terms rises dramatically, putting pressure on Japan’s economy. Japan is heavily dependent on oil to fuel its economy. 
• The Bank of Japan may need to intervene aggressively to prop up the yen. Japan may increase its interest rates, which would raise borrowing costs, making the carry trade less attractive.
• That could spark a global margin call as investors who have been borrowing cheap yen are forced to unwind their positions.
• The significant risk is that this could lead to a spike in credit spreads and a broader reset of the financial system.

Remember, the risk is due to the size of the carry trade. Borrowed money equates to leverage. All crises seem to be tied to leverage. Excess leverage blows things up. $20 trillion is a lot of leverage.

As a risk manager, I’m always looking for hot spots. The Yen carry trade has been ‘on my radar’ since 2014. A “bug in search of windshield” for more than ten years now. The bug is still flying. The windshield appears to be near. 

Global systems are complex. Developed country debt levels are off the charts, and equity market valuations are still too high. The geopolitical situation is worsening, especially in the Middle East. China, Russia, North Korea, Iran, and Venezuela. Tensions are growing; Sadly, I don’t see an offramp. Often, it is something we don’t see sneaks up from behind and kicks us in the rear. There is no guarantee it will be the unwinding of the carry trade, but if it is, the impact will be global since the exposures are global. It’s not just U.S. investors that make up that $20 trillion.

Watch the yen vs. the dollar and watch Japanese interest rates. And keep your eye on U.S. interest rates. It’s the spread between them that matters. Higher Japanese interest rates and a stronger yen could be a potential trigger. 

The conclusion is that the unwinding of the carry trade would have significant ripple effects across global markets, potentially leading to a flight to safety in US Treasuries and a broader reset of the financial system. There’s that “reset” word again. The bug hitting the windshield could be one of the triggers. Chin up, lights on. Just take in the data. Risk can be managed if you know what you are doing. 

Grab your coffee and find your favorite chair. The 10-year Treasury Note broke below 4% this week. We’ll take a look. It was a rough week for stocks. Intel is down 27% today, and it plans to lay off 15% of its workforce. Ouch. Also, check out the Random Tweets section. Especially Ian Bremmer’s comments on the recent assassinations in Beirut and Iran. 

Thank you for reading. I really appreciate the time you spend with me each week. I apologize in advance for any typos. My editor is in London for the month of August. I’m flying solo. That’s generally not good. 

On My Radar: 

• The Direction of Interest Rates 
• Random Tweets 
• Personal Note: August Heat 
• Trade Signals: July 31, 2024 Update 

Source: StockCharts.com

During the week, I also shared the following post with Trade Signals subscribers and will share it with you today. My good friend Barry Habib and his team at MBS Highway have done an excellent job forecasting the direction of interest rates and mortgage yields. He’s been ahead of most analysts in focusing on the unemployment rate. I asked him if I could share this post with you. Click on the photo to watch the update. Most of MBS’s customers are real estate professionals but others, like me subscribe to the service. Go to www.mbshighway.com to learn more. I like the music they choose to kick off each video. Worth the watch and fun!

If you’d like to learn more about Trade Signals, send me a reply to this email if reading today’s OMR in your inbox or email Amy@cmgwealth.com. The service is free for clients.

This is not a recommendation to buy or sell any security. It is for educational discussion purposes only. Opinions are subject to change. Consult your advisor. 

I “like” and “retweet” posts I find interesting. I enjoy X because I can easily follow people I like to keep On My Radar.

You can follow me on X (formerly Twitter) @SBlumenthalCMG.

You can also listen to my podcasts on Spotify, and find me on LinkedIn.

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Personal Note: August Heat 

Steve

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Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Private Wealth Client Website – www.cmgprivatewealth.com
TAMP Advisor Client Webiste – www.cmgwealth.com

Forbes Book – On My Radar, Navigating Stock Market Cycles.  Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.

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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.

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Written Disclosure Statement. CMG is an SEC-registered investment adviser located in Malvern, Pennsylvania. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy, or exclusively determines any internal strategy employed by CMG. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at www.cmgwealth.com/disclosures. CMG is committed to protecting your personal information. Click here to review CMG’s privacy policies.Please take note of the following text:

 

“The blue line in the lower section shows how much the orange line is above or below the long-term trend line. It is currently in the “Overvalued” zone. Lastly, the data boxes at the bottom of the chart display the annualized gains based on each zone (Overvalued, Fairly Valued – blue line in the middle zone, or Undervalued).”Please take note of the following text:

 

“The blue line in the lower section shows how much the orange line is above or below the long-term trend line. It is currently in the “Overvalued” zone. Lastly, the data boxes at the bottom of the chart display the annualized gains based on each zone (Overvalued, Fairly Valued – blue line in the middle zone, or Undervalued).”