It appears that all my warnings about Japan may be coming true.
For months, I have highlighted the very real risk of a currency crisis driven by the yen. For decades, Japan has been the source of tremendous leverage for the global financial system due to what’s known as the carry trade. The Japanese carry trade involves borrowing Japanese yen and investing the borrowed funds into assets with higher yields, often in different countries.
When traders engage in the carry trade, they often purchase higher-yielding assets such as foreign equities, which can drive up stock prices in those markets due to increased demand.
Conversely, if the carry trade unwinds — often due to a sudden increase in Japanese interest rates, a surge in yen short covering, or times of financial stress — it can lead to a swift selloff in those assets, including stocks, as traders rush to cover their yen borrowings. This can result in increased volatility and downward pressure on global stock markets, illustrating how interconnected financial strategies can have far-reaching effects.
What Does Bank of Japan Intervention Mean?
Now, because of the most recent yen movement and subsequent intervention by the Bank of Japan, Pandora’s Box may have opened.
Recall that key to my argument all along was that the Bank of Japan would at some point be forced to save the yen from depreciating against the dollar. This is because the weaker the yen gets, the more expensive oil priced in yen becomes. And because Japan imports all its oil, the risk becomes severe cost push inflationary pressure.
The Bank of Japan can undertake a series of monetary policy actions to strengthen the yen. These include tightening monetary policy by raising interest rates, which can attract foreign investment due to higher returns, thus increasing demand for the yen. In practice, this is nearly impossible to do given high interest rate differentials. The BoJ could also intervene directly in the foreign exchange market, buying yen and selling foreign currencies to increase its value. Additionally, the BoJ might look to reduce its balance sheet by selling government bonds, which would decrease the money supply and could lead to a stronger yen.
However, the central bank must carefully consider these potential actions as they could have significant impacts on the Japanese economy, potentially slowing growth or affecting inflation rates. The latter of which becomes a very serious problem.
Either way, the point remains the same. We are at the point in the story where the BoJ must act, and the impact could be far more consequential than anyone can imagine.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
