EXPLAINING AND SIMPLIFYING THE JPY (COUNTERINTUITIVE) “DOOM LOOP”

Last week, I ventured a bit too deeply into the plumbing of the global financial system with the article “THE JPY (COUNTERINTUITIVE) DOOM LOOP – THE MORE JPY LOSES VALUE, THE MORE LEVERAGE IS FORCED TO COME OFFLINE, THE MORE THE JPY LOSES VALUE” and I apologize to all those who got lost in that journey. Today, I will do my best to simplify things to a point that by the end, I hope not only what’s going on with the #JPY will be clear for everyone, but also the future consequences of this will be clear.

First of all, it is important to understand why increasing interest rates will still be devaluating the #JPY. Imagine you buy a brand new car with a loan, then once driving out from the car dealer you crash the car. Your asset is now totally worthless, right? But the loan you took remains. This is what happened to #Japan in the early 90s. Now, of course, you need a new car to move around, go to work, go to buy groceries, and so on, so you buy a second one starting a second loan that the car dealer is more than happy to provide since that money sitting in his account at zero percent will be otherwise totally unproductive. How can you afford the second loan if you could just afford the first? The #BOJ fairy will make a credit card appear where you can expense anything without ever worrying about paying the bill because she got it covered. How does the fairy pay the bills though? She will magically print money out of thin air… for more than 30 years. Fascinated by her powers, one-day #Japan prime minister Abe has a “great” idea: let’s ask the fairy to print some extra money to make investments so the overall debt can be repaid faster. Unfortunately, “Abenomics” not only did not work but “greatly” backfired leaving #Japan with a burden of debt, now above 260% debt/GDP, impossible to handle.

All I described above happened while interest rates in #Japan were either zero or negative. What do you expect will be the effect of starting to lift interest rates? The cost of debt will increase. How will this be paid? Issuing even more debt. Who will be the buyer of this newly issued debt? The #BOJ fairy. How will she pay for it? Printing JPY out of thin air…. This by itself is already the perfect spiral to trigger a currency crisis (WHY A HISTORICAL $JPY CURRENCY CRISIS IS AT THE DOORSTEP OF #JAPAN), however, things for #Japan are even messier.

The #BOJ fairy started to become more popular outside #Japan, many banks and asset managers wondered why she could not print some extra #JPY and hand it over to them for free to speculate in their own home markets. How many extra #JPY do you think the #BOJ fairy printed? About 1 Trillion #USD that then became the infamous $ Trillion + #USD #JPY carry trade market if we include all transactions and derivatives involved (961,361,277,445 #USD).

Alright, now let’s dive, this time slowly, into the #JPY doom loop made more acute by the #JPY carry trade unwinding to make something intuitive that has been counterintuitive for almost everyone so far.

The JPY Carry trade has 4 main components:

1 – Borrow JPY (at zero or insignificant interest rate);

2 – Exchange those JPY for foreign currency, #USD the most popular (by far);

3 – “Hedge” the risk #JPY will increase in value making the borrow at point (1) more difficult to repay; and

4 – Invest the foreign currency into foreign assets at much higher returns than the cost of the #JPY borrow.

Let’s assume the money has been invested to buy US Treasuries, the moment these mature all the components of the carry trade net each other and the investor keeps the profits. However, what if you bought 30 years US Treasuries, you still have to wait 20 years for them to mature and their current market value is 70% of what you paid originally? Here is where the troubles begin.

As we saw at the very beginning of the article, the Japanese government on its own is a vast contributor of #JPY depreciation through a combination of its policies (with no painless way out anymore). This has a big impact on point (3) of the #JPY carry trade structure. Why?

When the hedging of the JPY carry trade is put in place, the derivatives broker will lose money if #JPY appreciates, while vice versa will make money on its position against the investor if #JPY depreciates. Here there are 2 factors that come into play:

1 – The more the #JPY loses value the more collateral the broker will demand from the investor to cover the increasing Net Present Value (on its favor) of the derivatives position

2 – The broker will use that collateral to SHORT #JPY to maintain its position delta-hedged against #USD.

So 2 things happen behind the curtains the more #JPY loses value:

1 – Investors will be required to post more and more collateral

2 – The brokers will short more and more #JPY in parallel

What happens when the investor runs out of collateral and they are forced to unwind the JPY carry trade? The broker will receive #USD, either directly from the investor or by selling the collateral in the market, sell them to buy #JPY, and then net its short positions against #JPY. As you can see this is a zero-sum game from a currency perspective since positions are being netted in the market, however, what goes offline is the amount of leverage enabled by the #JPY carry trade in the first place (that enabled the bubbles in many foreign markets from #bonds to #stocks).

The investor has a problem though, the foreign assets he bought before are now worth much less than the #USD amounts they are supposed to repay to the brokers, as a consequence the investor incurs a CAPITAL LOSS at the very moment his collateral is being liquidated in the market.

As you can see at this point, the investor’s leverage is coming under pressure broadly with the brokers demanding a higher amount of collateral (on every borrow, not just JPY carry trade) because they factor in increasing capital losses.

Here is where the difficult part comes, in order to hedge its currency exposure the investor stuck into a bleeding carry trade does not want to unwind the carry trade to not incur capital losses. As a consequence, they borrow more #JPY so now they can SHORT them in the market to cover their exposure. Where do they get these extra #JPY from? From the #BOJ fairy that keeps printing #JPY out of thin air because of the growing amount of Japanese government debt, they are forced to monetize putting even more depreciating pressure on the #JPY as we saw at the very beginning of this article.

This is why the #JPY is stuck into a “doom loop” and this is why #JPY does not increase in value if the various positions we observed are unwound because when this happens it’s a zero-sum game. As you can see, the leverage that comes offline does not disappear but comes back into the Japanese financial system which is consequently flooded with more and more liquidity no one needs hence exacerbating the inflationary dynamics within the country.

This is also why #BOJ interventions in the market are now totally ineffective and it will come to a point that the more reserves they sell in the market to defend the #JPY the fewer “assets” will be available as a guarantee of the ballooning JPY debt being piled up by the government non-stop (that not only is facing a higher cost of debt but also running a deficit spending on top).

I hope the #JPY “doom loop” is now clear to everyone following the evolution of this monetary disaster.

What will be the consequences of all of this? As we discussed above, investors running a capital loss sooner or later will be forced to dump their foreign #stocks and #bonds ultimately deflating the bubbles #Japan contributed to create in the past 30 years.