Did BoJ just do a Pearl Harbor on Wall Street?

Is the Friday meltdown on Wall Street a precursor to a larger collapse in coming days?

The Nasdaq Composite lost 2.43% to close at 16,776, a more than 10% fall from its recent all-time high, while the Dow Jones Industrial Average fell 610 points (1.51%), to 39,737, a shade better than its intra-day low of 989 points. The free-fall on Wall Street comes amid investor worries over the delayed cut in interest rates by the US Federal Reserve, risking a sharper US economic slowdown as the unemployment rate hit 4.3%, the highest since October 2021.

Though the Fed has indicated that it is on course to cut rates in September, is the Street more spooked about the fallout of unravelling of yen carry trade, following the Bank of Japan hiking the benchmark rate from 0%-0.1% to 0.25% on July 31?

The Yen Carry Trade Risk

For years, Japan’s low interest rates made it attractive for investors to borrow money in yen and invest it in countries with higher returns, despite the exchange rate risks. According to ING Bank NV, data from the Bank for International Settlements (BIS) shows that banks' yen-denominated cross-border claims reached ¥328 trillion (around $2.2 trillion) as of March 2024, a 52% increase (equivalent to $742 billion) since the end of 2021. Crucially, this increase was primarily driven by interbank borrowing, which reached ¥123 trillion (around $0.83 trillion) as of March 2024, almost double the ¥67 trillion (around $0.45 trillion) at the end of 2021.However, data shows that the yen has appreciated YTD against the dollar by 3.91% to 146 and 33% since 2021.

In fact, the appreciation could be partly led by money flowing back to Japan and the fact that the Japanese central bank might have spent nearly 6 trillion yen ($38.4 billion) in July to prop up the currency against the dollar as a depreciating yen results in higher inflation. In fact, last June, as the yen hit 160 to the greenback, Masato Kanda, vice finance minister for international affairs, had publicly stated: "excessive fluctuations negatively affect the economy. We are ready to take appropriate action at any time" and that the central bank would take appropriate steps "any time.” In fact, BoJ Governor Kazuo Ueda did not rule out the possibility of yet another hike during the year, indicating the central bank's readiness to keep raising borrowing costs to a level deemed neutral to the economy. “If the economy and prices move in line with our projection, we will continue to raise interest rates. In fact, we haven’t changed our projection much from April. We don’t see 0.5% as any key barrier when raising rates,” told reporters at a post-meeting on July 31.

According to a commentary by Chris Turner, Global Head of Markets and Regional Head of Research for UK & CEE, and Dmitry Dolgin, Chief Economist, CIS, at ING Bank NV, ), with USD/JPY now trading at 149, the net speculative position has dropped to 22% of open interest as against 48% seen at the start of July. As per the Commodity Futures Trading Commission, cumulative bearish bets against the yen is $8.61 billion, though 40% lower from April's near-seven year high. However, ING duo believes that while positions are better balanced now than it was in July, the speculative market is still short yen and as a back-of-the-envelope calculation shows that 152.50 was the average entry for USD/JPY speculative longs built between January and July this year. “To what degree that international borrowing has been FX-hedged is impossible to know, but presumably the prohibitively expensive costs of hedging the dollar against the yen since 2022 mean that FX hedge ratios on this borrowing have remained low. We mention this because these unhedged cross-border yen loans could represent another and substantial layer of the carry trade. And whether the sharp sell-off in USD/JPY and rise in volatility sparks a much deeper layer of FX hedging remains a risk,” states the ING report.

From the end of 2021, the yen to dollar exchange rate has depreciated from 115 to about 146, which is a decline of around 27%. For simplicity, assuming 10% of the JPY 123 trillion (approximately $0.83 trillion) inter-bank borrowing is unhedged, this would translate into JPY 12.3 trillion ($84.25 billion) unhedged position, meaning it will cost you more dollars to repay the same amount of yen. Following the appreciation, the increased repayment cost owing on the unhedged position would be substantial, resulting in significantly higher costs for borrowers when converting their local currency to yen for debt servicing.

History rhymes

Why the yen appreciation is a concern is because of the ramifications it had in the run-up to the 2008 global credit crisis. According to a 2009 report by the IMF, the Tokyo office of the Wall Street bank has yen liabilities to Japanese banks but has yen assets against its New York head office. The significant yen liabilities and net assets of foreign banks in interoffice accounts indicated large-scale funding activities outside Japan, which were unwound sharply as the credit crisis unfolded.

As per the report, foreign banks have generally maintained negative interoffice net assets, consistent with the foreign banks maintaining a net long position in Japanese assets. However, in the period leading up to the beginning of the credit crisis of 2007, yen liabilities of foreign banks surged, leading to an unprecedented net positive interoffice account. Such positions are tantamount to the foreign banks maintaining a net short position in Japanese assets. These net short positions were unwound sharply in August 2007, coinciding with the initial stages of the credit crisis, and were reduced further as the credit crisis developed into the latter half of 2007 and into 2008, reveals the report.

This is where the risk lies.

According to a report by Shanghai Commercial Bank, as of March 2023, U.S. banks in Japan had yen 31 trillion in net liabilities, which means that US banks owe more yen to their offices in Japan than they hold as assets. This setup can be risky if the yen appreciates further because the cost of repaying these yen liabilities will only increase.

Since the yen borrowings are invested across various asset classes, including U.S. Treasuries, corporate bonds, equities, real estate, commodities, emerging markets, forex trading, and loans to clients. The subsequent appreciation of the yen, could reduce net returns or even lead to losses across.

Whether we are in 2008 redux will be visible on the Street in the coming weeks.