Source: Paul van Eeden Newsletter
Stocks rallied this week when tame retail sales figures were reported (Wal-Mart’s same-store sales rose only 1.2% for June, Costco reported weaker than expected June sales and Gap’s June same-store sales fell by 6%) and Monday’s stock market rally was apparently based on weaker than expected manufacturing activity: June’s reading of manufacturing activity from the Institute for Supply Management was the weakest in almost a year.
The Wall Street Journal reported today (Thursday June 6th) that the rise in stock prices was due to weak economic data that indicated a slowdown in the (US) economy. The reasoning goes that a sufficient slowdown in the economy will cause the Federal Reserve to stop raising interest rates, and since higher interest rates are generally bad news for stocks, then a hiatus in rising interest rates should be good for stocks.
You don’t have to be a genius to figure out that when the market hopes for bad economic news and interprets them as good news, something is wrong. Since when are falling retail sales good for stocks? Since when is reduced manufacturing activity good for stocks? Are stock traders so obsessed with the Fed’s next move that they forget to look at what is really going on?
If the US economy is slowing down, as confirmed by tepid retail sales and slowing manufacturing activity, then it is merely a matter of time before corporate earnings come under pressure and stock prices start falling.
When the market becomes this shortsighted, you should know that we are in a dangerous environment. Anything can happen. What is more, many investors in the US seem oblivious to what is happening in Japan, and the consequences for worldwide economic activity and investment returns.
Japan has been a major source of international monetary liquidity since 2001 when it embarked on a (near) zero interest rate policy coupled with a managed exchange rate between the yen and the dollar. Essentially it meant that large institutions (read hedge funds) could borrow yen at almost zero interest and invest the borrowed money in Europe and the US. Even with low US interest rates there was still a lot of money to be made: if you can borrow yen at say 0.35% and invest the money in US bonds at say 3%, you make 2.65% a year. Now, if you have say $100 million in capital but you borrow $1 billion in yen and make 2.65% on that money, you actually make a 26.5% return on your capital. That’s a lot of money, and it only requires a 3% yield on the bonds you buy. You can add another 10% return on capital for every 1% additional yield assuming you have 10:1 leverage.
The scheme works as long as Japanese interest rates remain low but, far more importantly, it only works as long as the yen does not appreciate against the dollar (or the euro if that’s where you invested the borrowed funds). If the yen appreciates by more than the interest rate differential then a potential profit will quickly turn into a real loss, and with the amount of leverage typically employed by hedge funds it would not take a large increase in the yen exchange rate to wipe out a lot of capital.
Recall Greenspan’s bond market enigma? Short-term interest rates were rising but medium and long-term rates were falling or, at best, staying flat. Obviously there was a lot of demand for medium and longer-term US bonds. Some of that demand came from the central banks of China and Japan who used US dollars they received in trade to buy US Treasuries in support of the dollar, and some of the demand came from international hedge funds, who were making good use of the yen-dollar carry trade as discussed above.
Japan started warning the world in early March that it had reached the end of its zero interest rate policy and current estimates are that the Bank of Japan could start raising rates as soon as next week or no later than August. This means an end to the yen carry trade, not just because profit margins will get squeezed, but more importantly because Japan will most likely allow the yen to start appreciating at the same time. The profit margins of the yen carry trade have actually never been better, since interest rates, especially in the US, have been rising while they remained low in Japan. It is therefore not a contraction of the nominal difference in interest rates that becomes the biggest risk for the carry trade, but the prospect of currency exchange losses if the yen appreciates.
The yen is already up 1.9% against the dollar since the beginning of the year, eroding a large part of the yen carry trade profit. It has also become quite volatile. From the first week of March, when Japan announced its intention to abandon the zero interest rate policy, to mid-May, the yen appreciated by more than 5% before correcting again. Hedge fund managers long on dollars and short on yen must have had more than one sleepless night during that time.
In addition to shutting down the yen carry trade, the Bank of Japan is also reducing the monetary base. Since January, Japan’s monetary base has declined by almost 20% — that is a massive decline and, as far as I know, unprecedented in history. There is no doubt that Japan is serious about curtailing the expansion of its money supply. The combination of less money supply and rising interest rates will put a serious dampener on yen liquidity and, by extension, international liquidity since Japan has been a major source of liquidity during the past five years.
Now let’s go back to our own little corner. At the moment investors are rejoicing at the prospect of slower economic growth, perversely believing that it is good for the stock market. What they fail to realize is that over and above the structural problems in the US economy a contraction of international liquidity as the yen carry trade shuts down will exacerbate any weakness in any economy going forward.