The end of a beautiful era: the yen threatens a new crisis in the United States and Europe

On Friday, December 19, Kazuo Ueda, head of the Bank of Japan (BOJ), may announce another step towards normalizing monetary policy. The market predicts a high probability of an increase in the key rate to 0.75%. This is still a very low rate, several percentage points lower than that of the US Federal Reserve or the European Central Bank, but the change is significant. For Japan, which has lived for decades in conditions of near-zero or negative rates, this is a tectonic shift. However, not only for Japan, the effect will be felt all over the world. Read the Izvestia article about why the increase in the BOJ rate is important and what kind of blow it can inflict on the global financial system.

A Samurai gift

The main problem with the rate increase is not the rise in the cost of loans for Japanese businesses, but the inevitable curtailment of carry-trade operations. For many years, this mechanism has served as a "circulatory system" for speculative capital around the world. Its shutdown threatens disruptions in the financial markets from New York to Frankfurt. In fact, carry-on trading is the same age as the current super—complex global financial system. How it will function without him in a high-stakes environment is not yet very clear.

Photo: REUTERS/Jeenah Moon

The essence of the carry trade is simple, like all financial arbitrage schemes. The investor borrows the currency of a country with a low interest rate (in this case, the yen), converts it into another currency and invests in assets that bring higher returns (for example, US Treasury bonds, shares of technology giants or currencies of developing countries). The difference between the loan rate in Japan and the return on the asset abroad is the profit of the speculator. In addition to the Japanese yen, similar schemes are used with the Swiss franc and the Chinese yuan. But the franc is a relatively "small" currency in terms of trading volume, and the yuan is still not fully convertible. Yen loans account for the lion's share of global carry-trade transactions.

This mechanism originated back in the 1990s, when Japan lowered interest rates to zero in an attempt to overcome deflation. Global funds quickly realized that the yen is an almost free resource, loans at 0% or 0.5%. As a result, the Japanese currency has become the main source of funding for global markets. This money was used to buy American treasuries (government bonds) and British ones, as well as, in recent years, cryptocurrencies and bigtech shares.

Photo: Global Look Press/Yoshio Tsunoda/AFLO

The scale of this phenomenon is difficult to estimate, as many transactions take place through derivatives and over-the-counter markets, but we are talking about trillions of dollars. It was the carry trade that provided excess liquidity, which pushed quotes up even when the fundamentals of the economy did not suggest this.

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For the second round

By itself, an increase in the rate to 0.75% is still not critical. But it also has some consequences. Carry-trade works only under two conditions: maintaining a wide spread (difference) in rates and a stable or weakening yen exchange rate. The actions of the Bank of Japan are striking on both counts.

When the cost of borrowing in yen increases, the marginality of operations decreases. At the same time, Tokyo's tightening policy leads to a strengthening of the yen. This is a double blow for an investor: not only is it more expensive for him to service the debt, but the very "body" of the loan in terms of dollars or euros becomes larger. To repay the debt, the trader is forced to urgently sell his assets (stocks, bonds) and buy the yen, which further pushes the Japanese currency up and starts a chain reaction of sales.

Photo: Global Look Press/AFLO

The "dress rehearsal" took place in August 2024, when the Bank of Japan unexpectedly raised the rate to just 0.25%, which caused the markets to experience a "black Monday". The Japanese Nikkei 225 index collapsed by 12% in a day (the worst result since 1987), and a wave of panic swept through all exchanges, crashing the quotes of technology companies and cryptocurrencies. Then the situation was stabilized with verbal interventions, but the structural problem did not go away. Now that the rate may rise to 0.75%, the pressure on the system is increasing. Moreover, not only the rate hike itself is important (it has already been largely planned by the market), but also Ueda's rhetoric. A hawkish attitude can have a much more devastating effect.

America and the Crypto Market

The most liquid and overheated markets will be the first to be hit. First of all, it is the USA. A significant portion of the yen loans were spent on buying shares in the American technology sector, fueled by the boom in artificial intelligence. A massive exit of investors from these positions to cover debts to Japanese banks could trigger a deep correction on the NASDAQ and S&P 500.

The situation with the US national debt is also not very clear. The expectation of a rate hike in Japan has already led to several spikes in the treasury market, with yield spikes. Given the somewhat vulnerable position of these instruments in the light of the huge budget deficits in the United States, the impact may be more than serious.

Photo: IZVESTIA/Yulia Khramtsova

The cryptocurrency market is even more vulnerable. Bitcoin and other digital assets traditionally act as a "sponge" for excess liquidity. In conditions of cheap money, investors are risk-averse, but as soon as the cost of capital rises, they are the first to dump highly volatile instruments. The correlation between the yen exchange rate and bitcoin quotes becomes extremely high in times of stress: the strengthening of the Japanese currency almost always means a drop in the crypto market. Now bitcoin is predicted to fall immediately to $ 70 thousand.

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European vulnerability

However, it is a mistake to assume that the problems will be limited to the Pacific region and Wall Street. For Europe and the UK, the curtailment of the carry trade carries specific and very painful risks.

Firstly, the financial systems of London and Frankfurt are closely integrated into global capital flows. European banks and hedge funds actively used cheap yen financing for operations with sovereign debt. With the eurozone and UK economies teetering on the brink of stagnation and budget deficits remaining high, any outflow of liquidity from the debt market is fraught with rising government bond yields. For countries with high debt burden (like Italy or France) this means an increase in the cost of servicing the national debt.

Secondly, the currency factor. The strengthening of the yen against the euro and the pound sterling will make European exports to Japan less competitive. But more importantly, European exporters (especially the German auto industry) often hedge their currency risks using sophisticated instruments tied to interest rates. A sharp change in the policy of the Bank of Japan may lead to losses on these derivatives.

Photo: Global Look Press/YOSHIO TSUNODA/AFLO

Finally, the United Kingdom, whose financial sector ("City") accounts for a significant share of GDP, is particularly sensitive to the global liquidity squeeze. If Japanese money, which has been "parked" in British assets (including real estate and government bonds) for years, starts returning home, the pound will come under pressure, and investment activity in the country, which is already going through difficult times, will slow down.

In general, it should be understood that the American market, for all its vulnerability, is protected by two things: the dominance of the dollar as the world's reserve currency (although it is being questioned, it is too early to talk about its end), as well as the AI boom, which has not yet developed into a full-fledged bubble. Many EU countries do not have such protection. Italy and France are suffering from a huge debt burden, and the latter also has deficits like in the United States, without being able to issue its own currency. In Germany, we see an acute industrial crisis and three years of recession, which has no end in sight. Germany does not suffer from excessive government debt, but the decision to issue loans worth hundreds of billions of euros over several years may shake up the national debt market in conditions of shrinking liquidity.

Traditional methods of dealing with the phenomenon — lowering interest rates — can make it even worse, as they will lead to a new surge in inflation. By the way, there was a break in the mass use of the yen carry trade in 2008-2016, but this was due to the era of ultra-low interest rates and five minutes of deflation on both sides of the Atlantic. Now, when inflation is holding at 2-3% and does not want to go away despite positive real rates, problems can arise very seriously.

Photo: REUTERS/Brendan McDermid

The decision of the Bank of Japan marks the end of the era of abnormally cheap money. The global financial system, accustomed to free "doping" from Tokyo, will have to undergo a painful "breakdown" and adapt to reality, where capital has a price again. For the countries of the European Union that are in a state of sluggish political and economic crisis, this price can be especially high.