Japan and the big carry trade

 

The yen carry trade has existed for decades. Borrow in cheap Japanese funding markets, sell yen, and then buy the currency of a high-yielding market in some other currency. Of course, hedging and risk management add layers, but the overall strategy is straightforward. Everything works until it does not, because of two things: 1) rates in Japan increase relative to the rest of the world, the yield spread falls; and 2) the yen appreciates, which can wipe out the gains from the spread differential. Now the Bank of Japan is raising rates, and the Finance Ministry is intervening in the yen markets to stop the currency slide. The net effect. is that less money will flow into foreign-yielding markets versus Japan. This will mean global rates will adjust higher.

Global bond markets are changing, and old sources of funding will no longer be available to borrowers. We can expect higher equilibrium real rates. We cannot say what the new rates will be, but the old environment is not working. 

Hedge funds and Treasuries - An unholy alliance

 

This may seem obvious, but hedge funds dominate a significant portion of Treasury trading. Their exposure exceeds that of mutual funds, and their behavior strongly affects market direction. These are not the same bond vigilantes of long ago, but a breed of arbitrageurs and directional traders ready to go long or short based on small market deviations. They are both liquidity takers and makers. Their turnover is significant, and they use substantial financing.

You have to ask: what happens if they change their strategies, or if losses elsewhere in their portfolio lead to deleveraging? Treasury prices are unlikely to rise, and liquidity will decline. Regulators have little to do. Do you want hedge funds to leave the market? Data from Decomposing Hedge Funds’ U.S. Treasury Exposures.

Big losses - big mistakes in finance from leverage

 

There are some common themes when it comes to large losses in finance - leverage kills. We cannot say that it is always the case, but a review of the biggest trading losses seems linked to excess leverage. Too much risk with a surprise event, and you have a recipe for losses. This will happen with funds and financials, and if we dig into corporate losses, we will find a link to leverage. What is surprising is that we haven’t had more large losses, given the spike in rates after the long period of low rates. 

We need risk management to protect ourselves from our leveraged behavior. 

Fed balance sheet - More work to do

The issue that has been important to Fed Chairman Warsh has been the Fed balance sheet. There still isn't enough focus on the dynamics of changes in the balance sheet, inflation, and credit. Total Fed assets are still more than 6 times higher than before the Great Financial Crisis, which was well over 15 years ago. Now, Fed regulatory rules have changed, so the total assets may be much higher for a normal state, but what is the proper number is still. not clear. We do know that over $8 trillion is too high, and more than 25% of GDP is also too high; yet, given inflation is still above target, we should see the balance sheet reduced further. The RMP program is going to zero, which will take out the small blip in 2026, but there is more work. Mortgages will roll off slowly given the low prepayment rates, but that is only a small portion, and the Fed is currently buying bills with the cash flow. There is reluctance to sell Treasuries given the Treasury's strong financing needs. 

To solve the inflation issue, the Fed will need to further reduce its balance sheet.