Bank of Japan rate rise – the new Y2K?

The entire global financial system is on the verge of disintegration, as the result of the imminent collapse of the yen carry trade – a rather apocalyptic quote from the UK’s Daily Telegraph in February of this year. Referring of course to the decision by the Bank of Japan whether to raise interest rates, and if so by how much.

As we approach the expected Friday announcement from the Bank of Japan (BoJ) that interest rates will increase from zero to 0.25 percent, the markets wait to see if the expected global fall out will occur. The main worry is the effect on the markets of the so called ‘carry trade’ – in effect getting money from Japan for nothing and then making a nice margin (‘carry’) by lending elsewhere, though still at very low rates. This is thought to have helped fuel speculation in risky emerging markets and commodities.

Although now facing extreme political pressure at home not to increase rates, the BoJ is not likely to resist increases this time. After all in the late 1980s, the BoJ’s image took savage beating when he bank bowed to political pressure to keep interest rates low, to help take the sting out of a rising yen while both the Nikkei and Japanese land prices jumped to unsustainable levels. This resulted in one of the biggest economic bubbles in global post-war history and ended in an inevitable collapse that ushered in over a decade of economic stagnation in Japan. As such it is expected that this time the BoJ will resist the political pressure and increase the rates.

So what of the carry trade?

Well, effectively, the BoJ has been handing out free money for all. Its original intention was to bring Japan out of the decade of deflationary depression, and spur on Japanese bank investment. The reality was, however, that the BoJ unwittingly became the bank to the world. In turn global investors could borrow money at less than one percent and then invest in US treasuries at increasingly higher interest rates. Provided the currency remained relatively stable, and the BoJ constantly intervened to see that it did, investors were laughing all the way to the bank. It was as good as a free profit.

Hedge funds currently leverage off this to supply cheap money into risky emerging markets to reap huge returns. If the supply of cheap money dries up then the funds are likely to pull out of these markets fairly quickly as the funds dry up. The major issue is that hedge funds are notoriously unsupervised and even worse, they tend to gear themselves much more, so as to gain higher returns. As markets come under pressure, the rate at which the funds will pull out is expected to accelerate rapidly – leading to likely collapse in these markets.

The other issue is that it is almost impossible to calculate how much exposure the hedge funds have – in effect, only after the damage has been done can the involvement be ascertained – so risk abounds.
Critics argue that the hedge fund managers are not stupid and that the exposure levels have been cut over the last few months and that other global events have precipitated the looming ‘carry trade’ issue already.

Overall, we expect that the effects of the BoJ announcement will run off in the same way as Y2K – essentially a damp squib – but we’ve stocked up on candles and tinned food just in case!

Sources

Dollar gains on trade data; rate uncertainty hits yen Marketwatch

Bank of Japan Rate Hike Could Be Global Economy Godzilla  Commerce Times

Will a BoJ Hike Rattle the Markets? Business Week

 Japan Bids Sayonara to Zero Interest Rates  AP (via chron)