4Alpha Research analyst: Kamiu.

Opinions in a nutshell.

• After the end of the macro big week in July, the US dollar, gold, and bitcoins all fell synchronously, and generally speaking, the probability of these three assets moving in the opposite direction is greater.

• The main reason is that the demand for additional margin for yen carry trades has led to a substantial increase in liquidity demand, and a large number of gold and bitcoin positions have been liquidated to provide US dollar liquidity.

• The Bank of Japan's rate hike this time reflects the attitude of the Japanese monetary policy authorities to maintain the exchange rate of the yen. There is no obvious causal relationship between the long-term and asset prices, but it may have a more profound impact on the Japanese macro economy and have a greater impact on Japanese foreign trade and high-end manufacturing.

First, the simultaneous decline of the US dollar, gold, and bitcoins in July is a low probability event, mainly due to the temporary liquidity shortage caused by the reversal of the yen carry trade.

Historically, it is a low probability event for gold and bitcoins priced in US dollars to decline significantly. Firstly, pricing in US dollars naturally represents the negative correlation between their prices and the US dollar index. When the US dollar is strong, gold and bitcoins will appear relatively weaker. Therefore, gold and bitcoins will move in sync with the changes in the US dollar index. Secondly, both bitcoins and gold are assets that are not controlled by sovereign monetary policy authorities. They have anti-inflation properties and high liquidity. The consistency of their intrinsic characteristics also leads to a generally positive correlation in their prices.

As assets that are negatively correlated with the US dollar index, for gold and bitcoins, when the prices or yields of US dollar-denominated assets such as US government bonds fall, it is generally understood that the prices of gold and bitcoins should rise due to capital inflows. However, in early August 2024, with a series of important economic data for July, such as non-farm employment and CPI for the second quarter, falling far below expectations, the signs of economic slowdown or even recession becoming more and more apparent, and the situation where the Fed's rate cut in September has become almost certain, the US dollar index plunged while the prices of gold and bitcoins also experienced a sharp decline.

We believe that this is mainly due to the first rate hike by the Bank of Japan after announcing the exit from YCC at the end of July, which led to the reversal of yen carry trades. After the economic crisis in Japan in the 1990s, in order to alleviate the balance sheet problems and runs on assets of primary market makers, Japan's monetary policy entered a long period of low interest rates to combat strong deflationary pressures, and the interest rate differential between Japan and the United States widened. In the 21st century, the impact of the 2008 subprime crisis combined with the slow actions of the Bank of Japan resulted in a more severe impact on the Japanese economy. At the same time, the aging population also led to increasing pressures on pension and medical insurance expenditures, and the financial burden eventually forced Abenomics to adopt more aggressive negative interest rate policies and larger scale QE expansion policies. Against this backdrop, the interest rate differential between Japan and the United States further widened, giving rise to yen carry trades.

Specifically, yen carry trades involve borrowing yen at extremely low exchange rates, then converting it into dollars and holding dollar-denominated assets. The traders engaged in this arbitrage trading are jokingly referred to as "Mrs. Watanabe". Under carry trades, they can basically enjoy risk-free interest rate differentials between Japan and the United States, which have been consistently above 3% (and can reach up to 5% in recent years). Therefore, in recent years, yen carry trades, as indicated by the amount of financing obtained by foreign investors in Japan, have become increasingly active. For example, Warren Buffett's large-scale borrowing of yen funds to purchase Japanese stocks is also due to the fact that yen-based financing has the lowest cost among major currencies.

Due to the unexpected rate hike by the Bank of Japan (policy interest rate) and unexpected hawkish comments from the Governor of the Bank of Japan, Haruhiko Kuroda, Japanese market interest rates, the yen exchange rate, and Japanese bond yields all surged simultaneously, causing the interest rate differential between Japan and the United States to narrow significantly and making carry trades no longer profitable and even resulting in losses. For many "Mrs. Watanabe" traders around the world, in order to avoid forced liquidation and margin calls, they have no choice but to liquidate other safe-haven asset positions (such as gold and bitcoin) and convert them into dollars to add margin. This process has caused significant selling pressure on bitcoin and gold, and has resulted in the rare phenomenon of simultaneous sharp declines in the US dollar index, gold, and bitcoin.

Therefore, the sharp decline in gold and bitcoin after the rate hike in yen is more due to incidental factors in terms of cash flow, rather than other macroeconomic fluctuations or fundamental reasons of cryptocurrencies. Currently, the long-term interest rate differential between the United States and Japan has fallen below 3%, and as shown in the chart below, the US dollar to yen exchange rate has continued to plummet after the rate hike, increasing the cost and difficulty of converting yen into dollars for carry trades. This suggests that the decline of carry trades will continue for some time. My preliminary estimate is about 3-5 months.

Historical data shows that besides Japanese related assets, the reversal of carry trades does not imply much about asset prices.

The reversal of carry trades will not have much impact on assets other than the yen and Japanese bonds in the long term, except for short-term shortages of US dollar liquidity and price fluctuations of safe-haven assets. There is no very clear pattern or causal relationship. After the burst of the 1990s economic bubble and the yen becoming the main carry trade currency, there have been 5 rounds of carry trade reversal in history. In addition to the reversal of carry trades causing capital inflows into Japan and the rise of yen exchange rates and Japanese bond yields during expansionary cycles, the response of global stock assets to each round of carry trade reversal has been inconsistent.

In 1998, 2002, and 2007, although Japan and the United States entered a synchronized interest rate downward trend, the rate cuts by the Bank of Japan were not as aggressive as those of the Federal Reserve, resulting in a narrowing of the interest rate differential between Japan and the United States and a reversal of carry trades. In 2015, when the market expected the Federal Reserve to end its rate hike process and the Bank of Japan increased YCC and 10-year government bond yield targets, although the interest rate differential between Japan and the United States did not significantly narrow, carry trades declined and reversed due to the market's strong expectation of a decline in the interest rate differential. However, the response of global stock markets in these five rounds of carry trade fluctuations has been inconsistent. Among them, in 1998 and 2022, global stock markets performed well, but in the other three cases, the performance of global stock markets was poor, making it difficult to summarize a reliable guiding rule.

However, the reversal of carry trades may accelerate the yen's interest rate hike process and may have far-reaching implications for the Japanese macroeconomy.

The yen exchange rate and carry trade have reversed, presenting a spider web-like cycle of strengthening logical transmission chains. The central bank's interest rate hike leads to a narrowing of interest rate differentials and a reversal of carry trades. The reversal of carry trades leads to capital inflows and the appreciation of the yen. The expansion of returns on yen-denominated assets further weakens the motivation for carry trade, forming a reinforced cycle. Faced with the sharp rise in the yen exchange rate this year, the Bank of Japan implemented an interest rate hike to maintain the stability of domestic purchasing power and openly protect the yen exchange rate. This is inherently understandable, but in the face of the perennial problem of the negative impact of the yen exchange rate rise on the Japanese economy, it seems that the current Japanese policy authorities have not provided a satisfactory solution.

Here, this article seeks to explore a frequently mentioned "paradox": the proportion of Japan's foreign trade economy in GDP does not seem to be that large, so why is the impact of exchange rates on Japan's foreign trade always emphasized and Japan's economy always described as export-oriented?

The reason is that Japan's exports are mainly industrial manufactured products, especially automobiles. The automobile industry, especially the rbob gasoline vehicle industry chain, is extremely long, and it can provide a large number of direct employment opportunities in the secondary industry (such as upstream parts factories) and supporting positions in the tertiary industry (the tertiary industry that serves industrial workers near industrial clusters). Moreover, compared with other non-trading sectors such as services, the production efficiency of Japan's automobile manufacturing industry is obviously more advanced. Due to the existence of the Balassa-Samuelson effect (as shown in the figure below), the high wage level in the manufacturing trade sector will quickly transmit to the non-trade sector, driving the development of the entire Japanese economy. This effect is far greater than the role reflected by the narrow sense of the proportion of foreign trade GDP. At the same time, large Japanese automobile brands such as Toyota and Honda have established a large number of factories overseas and sell directly in the local market (such as domestically-produced joint venture cars), which are not included in the GDP, resulting in an underestimation of the role of export-oriented industries in supporting the Japanese economy.

Therefore, under the premise of still weak domestic demand in Japan, a significant increase in the yen exchange rate is not good news for the Japanese automobile industry, which is fighting a tough battle globally with Chinese automobile industry, and the Japanese semiconductor industry, which is trying to revive its past glory. In the past 30 years, the Japanese economy and policy authorities have been struggling to resist deflation. Even if no contractionary policies were adopted and only slightly slower than the pace of the Fed's loose policies, it would lead to a substantial weakening of the economy. This time, the Bank of Japan has shown a clear hawkish attitude for the first time in many years, undoubtedly casting a shadow over the future of the Japanese economy in the short term.

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