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Why does this week's move in the yen matter so much?

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The Bank of Japan implemented QE and zero interest rate policy in the 1990s, in response to the implosion of a mega bubble. Since then, Japan has had a deflationary economy, i.e. the opposite of the post-Covid US economy.

Rather than get eaten away by inflation, money in the bank was able to purchase more goods and services in the future.

Because of which, the yen kept strengthening against all other fiat currencies which were on a race to the bottom.

Post-2008, the Fed followed the BoJ's lead and implemented QE and ZIRP. The commodity bull market took off. Capital was borrowed for cheap in US dollars and invested in far off places like Mongolia and Kenya, in search of oil, copper and gold.

Thus, the global carry trade was born. Until 2008, the theory of interest rate parity more or less worked in practice (Google it). When rates suddenly went to zero, IRP went for a toss.

Hence, the carry trade. Borrowers could take loans in USD, invest it in commodity producing countries, and repay the loans at a lower exchange rate, benefiting from both the low interest rate and USD depreciation.

In 2012, the commodity bull market went tits up. All those USD loans started weighing on commodity producing nations. The EU was in crisis, prompting a further bid on the dollar as capital fled the PIIGS crisis.

The USD entered a mega uptrend. The carry trade was over.

Enter the yen. The yen became the new carry currency, offering the same free lunch. Low rates and a guaranteed lower exchange rate in the future.

Whoa - just like that? Yes, just like that. It was the vision of Shinzo Abe when he came into power in 2012. He wanted to bring inflation back to Japan, in order to "jump start" the economy.

He came up with the ingenious idea of taking the economic equivalent of a defibrillator and shocking a healthy adult's heart.

His economic "advisor" was none other than the guy who said the impact of the internet will be no greater than that of the fax machine. The Nobel prize winner who vacuously said if you exclude food, energy, clothing, shelter & transportation from the CPI, it is already below 2%.

Japan implemented Krugmanomics starting in 2012. They labelled the campaign "Three Arrows". The first arrow - you guessed it, printing money. The second? Government spending. The third was vaguely titled "structural reforms". (It did not include illegal political slush funds - that scandal would come to light a decade later).

Enter Masa Son and SoftBank. They borrowed cheap and led private equity investments in tech, just as software started to eat the world.

They were so successful, they spawned a lot of imitators. Soon, everyone was borrowing in yen and investing in tech startups.

I'm sure the Japanese used the money to open a few sushi restaurants too, but let me stick with my story.

As long as the portfolio companies commanded a higher valuation with each round, the PE funds got to mark their gains. Borrowing increased, backed by slightly iffy collateral, but there was too much money sloshing around for valuation to become a pinch point.

Softbank launched a $100 bn PE fund in 2017, and followed up with a second $100 bn PE fund in 2019.

They used the money to invest in - among other things - WeWork. This was the height of the bezzle.

The infinite loop of BoJ money printing -> yen borrowing -> carry trade -> repaying in depreciated yen continued until everybody was doing it.

It became the most crowded trade, and that's saying something after just witnessing the Mag 7 bubble.

Enter Kazo Ueda, replacing the previous BoJ governor in April last year. The new boss was the same as the old boss. Except - he hiked rates all the way up to 0% (yes - zero) and made few tweaks to yield curve control.

But for the most part, he was happy to just let the yen lose value. The yen was winning the fiat currency race to the bottom. Other free floating currencies were trying not to participate in that rate, but the yen kept racing ahead.

On Monday this week, the yen hit 160 to the dollar. A 34 year low. And suddenly, Ueda decided enough was enough. The free lunch provided to the carry traders - at the expense of Mr. and Mrs. Watanabe - had to end. The American tourists could go buy their Louis Vuitton elsewhere. No more cheap yen.

The problem is, when you depreciate a currency for 12 straight years as a matter of policy, it is hard to convince FX traders that you mean business. The yen is now under attack. A new breed of traders who were in diapers when Soros attacked the pound have decided to make shorting the yen their hero trade.

The higher volatility and sudden yen strength has increased the cost of hedging and FX swap rates. Japanese banks are now in a pickle. The more the yen strengthens, the higher the likelihood their borrowers go bust.

But if they contract credit, i.e. start calling in loans, the drop in money supply lends further strength to the yen, which increases the likelihood of an explosive move higher in the currency (lower USDJPY).

Is the BoJ committed to holding 160 and intervening to preserve what's left of the yen's purchasing power and international status?

This is the question on the minds of everyone with a yen denominated loan.

This should be THE question on everyone's mind.

Having decided to intervene, if the BoJ fails, the consequences would be fatal for the currency, relegating Japan to the same state as Turkey, Zimbabwe, and the like. Not a very good outcome.

They cannot afford to fail. Other developed market central bankers will ensure they do not fail.

Which means the likely outcome is the failure of the speculative attacks on the yen.

This would mean the end of the carry trade, and a massive exodus of capital from US tech, which has been the chief beneficiary of cheap yen.

It also means the demise of SoftBank, given its gargantuan debt load. Masa Son is Korean. I imagine the Japanese officials would rather sacrifice SoftBank than the yen.

This answers the question: why has tech been weak even though the Fed is dovish?

The smart money has been de-levering all week. They know how this story ends and are hunkering for the financial storm.

Maybe you should too.

(I've simplified a complex topic, so of course there will be loose ends. No apologies for that).

Good Trading!


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