by Laurence Peterson
It is said that money talks, but recent signals from markets, economic indicators, and utterances from monetary policy makers all over the world now display all the comprehensibility of an overly enthusiastic believer speaking in tongues. Things had been hyper-sensitive since the Federal Reserve started raising the key interest rate (Federal Funds rate) from an historic low of 0.25% in early 2022 to 5.5% in August of 2023, but the last several weeks have produced a series of gyrations and blowouts that have been quite unique. Perhaps it is only because of the extraordinary (usually regarding their absurdity) happenings in the world of domestic politics and nothing less than atrocities on the international scene that many have allowed these events to fade from view. But then these developments have their own complicating effects on the same markets.
The most prominent cause of tension in the markets has involved two major forces pulling against each other: a weakness in the US labor market, and signs of increasing or plateauing US inflation. Any significant indication of momentum in either direction induces market players to pile in, reinforcing the trend. If the movement becomes dramatic enough, pressure builds on the monetary authorities to stem the accelerating tide by altering interest rates.
Since early July, poor monthly unemployment reports have resulted in lopsided reactions that have provoked alarm amongst Federal Reserve board members and monetary policy officials worldwide. Officials dropped hints that the first Fed rate cut in 4 years became more or less imminent, slated for the September 18th, 2024 Fed meeting. At first, few expected more than the usual quarter-percentage point cut. But when the second consecutive subpar report for July came in early August, markets worldwide panicked. US and European markets took significant hits, but the real damage, as is so often the case, was in the Far East and the less-developed world, although four of the most adversely affected markets were powerhouses like Japan, South Korea, Taiwan and China.
At this point, more and more calls for a .5% interest rate cut grew louder, and agitation favoring a rare between-meetings cut, even at an important monetary policy symposium in late-August, increased. The August Employment report, released in early September, showed less growth than had been forecasted, but the movement was far less dramatic than that of the previous two months. At this point, it was assumed by market participants that a Fed Funds cut was certain to be in the cards on the big day, September the 18th. The interesting thing here, at least in a recent-historical sense, was that the Fed did not intervene; that it managed to calm the markets by, well, doing nothing. That has been almost unheard of since at least 2008. But the calm was based on a firm expectation of a rate cut on the 18th; the only question that remained concerned whether it would be more than a quarter percentage point or more, like .5%, or even .75%. And if no cut was forthcoming, nothing less than immediate slaughter would ensue on the markets.
So far, the dynamics I have sketched out here may seem rather simple (and they are greatly abbreviated due to considerations pertaining to space), far from requiring the metaphor of someone producing a spectacular series of jagged gesticulations and spitty locutions—though one might wonder about how two relatively poor employment reports in succession could wreak such havoc. But a deeper look at what happened in early August clearly reveals how dangerously convoluted deeply divergent and potentially dangerous economic and financial forces have become. And nothing illustrates this thought more than carry trades, especially, but certainly not limited to the Yen (the Japanese currency) carry trade.
The really important carry trades now are trades in which investors borrow in currencies that trade at low interest rates to invest in assets selling in markets whose trades are denominated in currencies featuring higher interest rates. That way the investor borrows low and can sell high, pocketing a large differential, or spread. For some time, the most prominent trade consisted of borrowing in Japanese yen, which has, until very recently, been trading at negative rates, and investing in US dollar assets, whose interest rates have been 5.5%. Thus, an investor could earn a spread of close to 6 percent upon sale of the asset. But lower inflation readings in the US have been putting downward pressure on US rates, whilst in Japan, monetary authorities have been indicating for months that they were intent on raising interest rates into, and perhaps well into, positive territory. This spread looked like it might be compressed—considerably. And this, in turn would increase pressure on investors (many, many of whom have borrowed much more than they have invested themselves, vastly intensifying the pressure) to sell. John Plender of the Financial Times put it this way in early August:
After years of yen weakness and negative interest rates [the yen carry] trade has ballooned. For want of good data the dynamics of the unwind are difficult to read. But TS Lombard estimates that investors may need to find up to $1.1tn to pay off yen carry-trade borrowing.
The risk now is that Fed cuts to address soft labour markets and the threat of recession will cause more carry trades to unwind, with further disruption in markets globally.
One thing to notice off the bat here is that the data are scanty, in spite of the fact the market is enormous. This must also mean that the important players operate in unregulated territory, despite the fact that so many have borrowed so much money to make bets on these markets, or simply to hedge to maintain the value of their own assets. But it also behooves us to remember how bad the situation got. Adam Tooze provides this commentary:
On Monday August 5, the Japanese stock market index, Topix, closed down 12%, its worse (sic) performance since 1987. The scale of the Japanese market, its interconnection with the global system and the size of the moves have sent shock waves. Japan’s investors are, on net, the largest lenders to the world economy. The country’s investors owned $10.6trn in foreign assets at the end of last year. Japanese investors are huge buyers of American and Australian securitized loans. What happens in Japan matters to the entire world economy.
As The Economist described it for us, we are witnessing in Japan in recent days the unwinding of a basic discrepancy that has immediately to do with the uneven and polarized recovery from COVID, but can be traced back a decade to the aftermath of 2008 and the divergence between US and Japanese monetary policy around 2012/3….
What Tooze is illustrating here is that one of the most important trades in global finance has involved a basic contradiction at its core, one that takes on more stresses as the featured economies desperately attempt to normalize after fifteen-plus years of recovery (of a sort) from crashes of historic magnitudes, from which they can only really rebound in fits and starts relative to each other. So their monetary authorities have essentially been forced to operate at cross purposes with each other for much of the last several, crisis-ridden years. This means divergences will inevitably appear in markets that market players will exploit, and this, in turn will eventually affect economic performance. The monetary authorities will attempt to rein in what they see as excess movements especially regarding inflation and unemployment. But this will create further divergences with other economies which find themselves in different phases of the economic cycle and which exhibit vastly different sets of financial flows. At some point the skewered differentials reflected in currency movements and interest rates will come to rest on assets that become difficult to price properly, which causes markets to glut. This happened the last time with Silicon Valley Bank in 2023, and came to adversely affect the trading of even US Treasury bonds, considered the safest assets in the entire world. The Federal Reserve soon guaranteed deposits at SVB, leading to eventual market stabilization. But the underlying dynamics continue to fester and become more complicated, again dangerously outside of the view of monetary authorities or regulators.
It will be argued that though monetary policy may be conducted at by national authorities often at cross purposes with each other, the United States, and the Federal Reserve, maintain a definite primacy of all other central banks. This is of course true, but, like so much else in this story, the situation post-2008 has complicated matters significantly. Tooze, in a fine piece in Foreign Policy, “The Forgotten History of the Financial Crisis”, maps out how the United States became lender of last resort to foreign banks through “liquidity swap lines”, by which the Fed provided much-needed dollars to foreign central banks which required the what was recognized at the time as the only safe asset in the world. The significance of this?
Although swap lines could be dismissed as technical in-house arrangements between central banks, they represented a fundamental transformation of the global financial system. The world’s central banks effectively became offshore divisions of the Fed, conduits for whatever liquidity the financial system required. The Fed, that is, made itself into a global lender of last resort.
Tooze continues:
But in establishing the swap-line system, the Fed also confirmed a hierarchy of foreign central banks. The system included the obvious European central banks…it also included the central banks of major emerging-market centers…[t]hey were in…the likes of China, India and Russia were not. Veterans of the swap-line program at the Fed, who spoke to me on the condition of anonymity, admitted that they knew that by rolling it out they were straying into political terrain.
Also:
The swap line wasn’t secret, but it wasn’t trumpeted, either. This was no Marshall Plan moment, and US officials had no desire to publicize the fact that they were coming to the world’s rescue.
The Fed revealed a stark primacy during periods of acute crisis, but attempted to go its own way, and meet its own goals (and mandates, presumably), when it aimed to achieve an ever-evasive normalcy. Meanwhile, the Fed became concerned with the stability of the very European banks it had just saved.
The ultimate outcome of the crisis was an unwinding of the extraordinarily tight connection between US and European finance that had characterized the 1990s and the early years of this century…At the same time as European finance has deglobalized, emerging markets have taken center stage. Cheap dollar financing has sucked emerging markets into a deep entanglement with the U.S. dominated financial system.
Ultimately,
The actions taken by the Fed to manage the 2008 crisis were underpinned by the remnants of a transatlantic relationship dating back to the end of World War II; given today’s fraying transatlantic ties, it is an open question whether it will be able to repeat its efforts on a truly global scale when the next crisis arrives.
And then there are the structural weaknesses of the US economy, which is supposed to bear the burden of so much of this disaster protection and cleanup. For reasons of space, I cannot go into these in detail. Suffice it to say that we are talking about an economy in which three of the most essential services provided to the country’s citizens, housing, healthcare and education, involve to a significant degree markets that are badly broken, the waste in which serves to sap the economy in a cumulative way, year after year. Healthcare constitutes about 17.5% of the economy, real estate another 18%, and education 5.5% or so. Some 40% of the economy provides relatively poor outcomes for vast swathes of people, relative to peer nations, except inasmuch real estate is a mess nearly everywhere. All three seem disastrously dependent on low interest rates to finance ever-expanding indebtedness on the part of consumers, and that manufactured demand only serves to raise prices in these sectors, and pulls up general inflation even if other sectors show little sign of upward pressure. The monetary authorities are then thrown into the usual economic antinomies like the one facing the Fed right now. Yet nothing at all is done to address, never mind really deal comprehensively with these problems. This, to me, provides much of the raw material behind the extensive malaise many see in the US economy, even if other indicators suggest even robust growth. To add a fundamentally weakened economy to the admixture of stark vulnerability outlined above serves to suggest the following paraphrase of the famous quote: our economy has become a vulnerability inside a contradiction inside an exaggeration; and to expect to detect much lasting, consistent sense in its movements these days looks increasingly like a fool’s errand.
The Federal Reserve finally made its decision just now. It lowered the Fed Funds rate .5% to a range between 4.75%-5%. Markets are rather tranquil, given the unusually large size of the rate cut. It appears right now that no large trades are uncomfortably balanced on this move, at least not immediately. And how would I characterize events. Why, it’s simple: gwa ka me nyama dlong!
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