THE JPY (COUNTERINTUITIVE) DOOM LOOP – THE MORE JPY LOSES VALUE, THE MORE LEVERAGE IS FORCED TO COME OFFLINE, THE MORE THE JPY LOSES VALUE

Almost 9 months ago now in the post “$JPY CARRY TRADE – THE BIGGEST FINANCIAL TICKING TIME BOMB OF ALL?“, I tried to explain how, in the current market conditions where the shortage of quality collateral assets is becoming incredibly scarce, a depreciating #JPY would have put the ginormous and popular #JPY carry trade, a “sure win” no more, under pressure. In a nutshell, when someone borrows #JPY to invest in non-JPY assets (let’s assume US treasuries), the risk is hedged via FX swaps that are efficient both in terms of risk protection and cost (under the assumption that the differential in rates between US and Japan remains stable). However, there is a detail I do not understand why people keep ignoring: if the non-JPY investment leg goes underwater, then the investor faces capital losses in unwinding the JPY carry trade. This is what happens:

1 – #JPY depreciates and at, let’s say, 154, triggers a request for additional margin to the counterpart that holds the carry trade on the FX Swaps in place. Yes, if #JPY appreciates, the broker will post collateral, but if the opposite happens, that burden switches on top of the investor.

2 – The investor has two alternatives: either post additional collateral or unwind its carry trade. Of course, they will always prefer the first option since the second will force them to book a big capital loss in the current market scenario.

3 – Here is when the “doom loop” starts. No investor keeps their assets idle; these are always “put to work” to maximize portfolio returns. Translated, assets not pledged as collateral, hence in the availability of the investor, are constantly repoed out to source additional liquidity. How would they invest the additional liquidity? Easy answer: yield harvesting (from Reverse Repos against lower-rated bonds to the infamous short Volatility trades of any sort). Now it should be clear why an investor forced to post collateral will have less liquidity at his disposal due to the necessity to unwind their repos and deliver that collateral to their broker. Hold on a second, then why don’t brokers use that collateral to gain extra returns?

4 – The answer to the question above is no, why? That would be very capital inefficient for brokers who are not supposed to carry “directional” exposure but maximize their profits by making their balance sheet more efficient. How can that be achieved? If a broker receives collateral from an investor in 99.9% of the cases, it will re-pledge that collateral to the counterpart he used to hedge its own exposure. Furthermore, there is another problem here, the shift from a low to a high-interest rate environment will haircut collateral value significantly. This means that a counterpart being margin-called will have to post more than 100% of the collateral nominal value to its broker (and the broker will flip that over to its own counterpart).

5 – Now that we have seen how liquidity comes offline, it’s time to see why this puts additional pressure on the JPY once a JPY carry trade is being unwound. First of all, from an FX perspective, the unwinding of a JPY carry trade is a neutral transaction because the change in NPV is being constantly hedged by brokers. So when an FX Swap ceases to be in place, the counterparts simply exchange the original nominal amounts and in our case, if the investor defaults on its non-JPY leg, the broker will dump the collateral for foreign currency but still deliver the JPY nominal. The investor will incur capital losses on the non-JPY leg but as you can see, they will still have the JPY needed to repay their initial JPY borrows and close the carry trade.

6 – The original lender in the JPY carry trade will now see the currency coming back on its balance sheet. If the lender is a Japanese bank and they prefer to reinvest the JPY in JGB, that will put pressure on the JPY since the BOJ will be forced to print more JPY to pay for the increasing yields on Japanese government bonds (WHY A HISTORICAL $JPY CURRENCY CRISIS IS AT THE DOORSTEP OF #JAPAN). If the original lender is a Japanese shadow bank, in the current environment this is expected to pay back its own funding to the Japanese bank that lent to it in the first place or to reinvest those proceeds into JGBs (in both cases we are back in the situation I described just above). What if the original lender is a non-Japanese bank or shadow bank? You can hardly expect them to keep that balance in JPY while this keeps depreciating and offers a meager yield compared to those they can get in their local market. As a consequence, even in this scenario, the JPY balance will be dumped for a stronger currency.

7 – This last dump brings us back to point one when the “doom loop” began, but this time the FX rate will be at 155 instead of 154.

Putting it all together we now see:

• The #BOJ that keeps printing JPY the more yields increase and the more Japan government deficit spending increases
• A major Japanese firm leveraged through the nose is bleeding cash the more JPY depreciates (IF ARCHEGOS BUSTED CREDIT SUISSE, WHICH BANK WILL A SOFTBANK IMPLOSION SINK?)
• JPY carry trades unwinding putting downward pressure on the JPY

Several days ago I asked the question “HOW LONG CAN THE FED DELAY JAPAN’S (INEVITABLE) ECONOMIC IMPLOSION?” and now we are seeing how the battle over JPY is within a war already lost in particular when US inflation tied Jerome Burns’ hands behind his back and he is not in a position to even pretend he will cut rates in the foreseeable future (The great bet on rate cuts is off – FT)