Bank Of Japan And The S&P 500
Bank Of Japan Rate Decision
Has the Bank Of Japan set the near term direction of the S&P 500?
The S&P 500 in the U.S. experienced a significant downturn last week.
Many analysts will point to weakness in the Non-Farm Payroll and the increase in unemployment figures reported on Friday.
That has prompted those same analysts to warn that the U.S. economy may be in recession or that recession is on the horizon.
While U.S. domestic economic performance is a factor, the impact of the other central banks globally, particularly the Bank of Japan, should not be underestimated.
The Bank of Japan’s decision to raise interest rates to 0.25%, a historically significant move, was aimed at bolstering the Yen’s value. This marked a stark departure from the Bank’s negative interest rate policy, which it had maintained since 2009, and was the first such increase in 17 years.
The Nikkei 225 was down 6% on Friday, the most significant drawdown since 1987.
The Bank of Japan’s decision to increase rates to 0.25% will negatively affect global assets.
Since 2009, Japan has had exceptionally low borrowing costs linked to negative interest rates.
Most central banks increased interest rates post-pandemic. Japan, however, needed to induce inflation in its economy and has been actively holding its rates down. Japan has been in a period of super-low inflation because of its housing crisis/bubble. To drive inflation, the Bank of Japan has monetised massive debt.
As a consequence, the Yen became weaker and weaker.
The ‘Carry Trade’
Investors or traders could sell short Japanese bonds and receive Yen. They could then take that Yen and sell it for another currency. They could buy dollars and use those dollars to buy the higher-yielding U.S. treasuries. This strategy, known as the ‘carry trade ‘, involves borrowing in a low-interest-rate currency and investing in a higher-interest-rate currency, profiting from the interest rate differential.
The Yen was effectively the escape valve for the monetary manipulation by the Bank of Japan.
In essence, investors borrow money from the Bank of Japan for free and buy risk assets around the world.
The increase in interest rates by the Bank of Japan means that borrowing is no longer free. In addition, the Yen as a currency has strengthened. The previous carry trade is now going against the investors.
Investors will be concerned that the money they borrowed for free is no longer free, so they’re unwinding trades. As the ‘carry trade’ begins to unwind, the ripple effects will be felt across the financial landscape. Risk assets, which were once buoyed by this strategy, will now start to unravel as investors rush to pay off their loans before the interest rate change erodes their profits.
The estimated value of this unwinding is $4 trillion.
The only question remains how aggressive they will be in their unwinding.
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