Could Japan Produce a “Black Swan” Financial Market Shock?

By The Curmudgeon

We consider Japan as the most likely external source for financial market instability. Everybody knows about the cheap liquidity available from Japanese markets for “carry trades” and similar financial maneuvers based on borrowing of the ultra low yielding and weak Japanese Yen.  Did you also know that Japanese housewives are borrowing money to invest in foreign currencies?  That has put pressure on an already weak Yen and encourages more carry trades for leveraged hedge fund speculation in non- Japanese asset markets.

From a June 23rd Sydney Herald article, Housewives Show a Yen for Trading to Net Riches

“Japanese housewives, pensioners and other amateur traders are borrowing record sums to buy high yielding currencies such as the Australian dollar, in a speculative splurge that is prolonging a slump in the yen.”
The Bank of Japan's determination to keep its ultra low interest rate pegged at 0.5 per cent since February has encouraged the growing ranks of amateur traders to bet heavily against their own currency. So far this year they have opened 600,000 accounts at brokerages that lend money at the low rate for currency bets, according to Tokyo's Yano Research Institute.

A July 3rd IHT article takes the speculation by Japanese housewives one-step further.

In Japan, individuals have opened 664,802 margin trading accounts at brokerages that lend money for currency bets, almost twice as many as a year ago, according to Yano Research Institute of Tokyo, publisher of an annual report on the business. The number of those accounts may exceed one million by the end of March, said Kaz Shirakura, senior researcher at the institute. The amount of that balance totaled ¥613 billion, up 62.2 percent from a year ago, Shirakura added.

Nishimura went on to highlight the risk of households suddenly reversing their investment tactics. "We do not know how far the contrarian strategies of Japanese retail investors can go," Nishimura said. "A sudden change in their behavior is likely to shift the direction and the magnitude of trading in many foreign exchange markets."

So do Japanese housewives hold the hidden key to a reversal in carry trades and resulting speculation in other markets?  Would a domestic interest rate increase cause them to curtail their currency bets?  At some point soon, we think that the BoJ’s very stimulative monetary policy must end.  The Japanese stock market recently hit a 7-year high and the Japanese economy is expected now to grow by more than 3% in real terms, beating consensus estimates which are still near 2%.   A more conservative administration might take note of the growing Japanese economy and the passing of the deflation threat.  The BoJ might quickly raise its overnight rate to 0.75% and then to 1% (from 0.5% now).  Doing so would percolate throughout the credit and currency markets, causing many a carry trade to be unwound.

In his June 28th Brave Money posting, Sandeep Abbott states that the unwinding of the carry trades would “reverse the flow of money from emerging markets to their countries of origin in response to flow back to Japan. In the past, such unwinding have produced massive asset corrections in world equity and commodity markets. April, 2006 and February,2007  were  conspicuous by perfect correlation between appreciating yen and falling stock markets, Gold and other commodity markets . In fact, February 2007 saw crazy meltdowns of 6-7 % in just a week. Coincidentally, in February 2007 European central bank had warned against one way bets on yen just as Japanese Finance Minister has done now. Whether this coincidence plays out in results as well is to be seen.”

Many have noticed the inverse correlation between the Yen-Dollar rate and the S &P 500 index.

In particular, the Yen seems to rally on big down days for the S&P 500.  This is certainly an unwinding of carry trades, in our opinion.

So in addition to rising Japanese interest rates or a rising Yen, the carry trades are being liquidated when markets where traders are long (in this case the S&P) decline. Is there more unwinding to come?  Will the declines broaden to other markets?  Will they feed on themselves?  Only time will tell.

Author's Note:  The Curmudgeon whole heartedly endorses Nassim Nicholas Taleb's black swan theory: a large impact, hard-to-predict, and rare event beyond the realm of normal expectations. This was the case during the October 15- 19, 1987 stock market crash (it was actually a multiple day crash, contrary to what you may have read).  It was also the case after 9/11/2001.  Overvalued and extended
markets, like we have now, will suffer the most from such unexpected events.

Furthermore, the Curmudgeon believes that over 95 percent of so called "professional investors," are in fact amateurs.  They have not lived through a real (secular) bear market, they do not understand market dynamics, they have little respect for managing risk, and no historical  perspective.

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the
1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst
designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non correlated) investment accounts for clients from 1992-2005.