The rapid appreciation of the yen within the third quarter of this 12 months caught policymakers’ attention when it triggered a transient but devastating spike in volatility in major asset markets. The precise effects quickly became apparent. Settlement of yen carry trades estimated within the order of several hundred billion dollars triggered a vicious cycle of forced liquidations. As currency gains drove up the price of repaying yen loans that financed non-yen investments, attempts to rapidly sell non-yen assets to repay yen debts exacerbated each the yen’s rise and the collapse of local currency assets.
Even though market sentiment eventually recovered and volatility subsided, the existence of sizeable fair-weather carry trades – enabled by foreign currency lending from institutions – attracted policy attention. An illusion of “abundant liquidity” mixing “sticky” money supply with “transitory” flows likely exaggerated economic system resilience and market depth.
In reference to Warren Buffett’s remark that “Who swam naked only becomes apparent at low tide”, temporary liquidity from carry trades was a part of a recent phenomenon that kept the “water level” of the markets artificially high and the swimmers joyful not less than until the third quarter of 2024, highlighting the fleeting nature of “borrowed liquidity”.
Fungible money ensures rising asset prices despite rate of interest hikes
In a subsequent interviewBIS economic adviser and head of research Hyun Song Shin reflected on the impact of the unwinding of the yen carry trade. Before the volatility episode, asset markets were recipients of inflows from institutional currency lending, commonly generally known as FX swaps. Such swaps link sources of low cost liquidity – akin to Japan – with markets with higher-yielding assets – akin to the United States. Amid increasing FX swap flowsYen carry trades steadily evolved from Small investors in Japan invest yen savings in higher-interest foreign exchange to market-moving institutional “yield-seeking” flows.
Figure 1.
While FX swaps were originally designed for currency hedging, Shin noted that the financial use of FX swaps to convert borrowed money into foreign exchange now accounts for the lion’s share of this market. Thus, institutions which are “not constrained by the funding currency” can raise liquidity wherever it’s economical to accomplish that, and FX swaps “project” those funds from one market to a different, potentially drowning out local monetary policy actions and market signals.
Shin suggested that if money is already “fungible across currencies” in the present system, such borderless money undermines the importance of local money supplies controlled by national central banks. This also explains the puzzling coexistence of high rates of interest and buoyant asset valuations. If money supplies are tight within the United States but loose in Japan, foreign exchange swaps can convert low cost liquidity under the BOJ’s easing regime into “fungible dollars” to purchase U.S. assets and undermine the effect of Fed tightening.
This also explains the spike in volatility in Q3 2024 and the next recovery in risk sentiment seen in Figure 2. Both didn’t coincide with any significant changes in domestic liquidity conditions within the US, as carry trades pump or inject “temporary” liquidity that’s unrelated to domestic liquidity conditions and falls under Fed supervision.
Figure 2.
Unlimited, volatile liquidity complicates policy implementation and increases market volatility
Under the present central bank framework, asset prices are Key to monetary policy transmission. The level of risk appetite in equity and company bond markets, short-term and long-term rates of interest and currency valuations function tools for central banks to Influence on the actual economy. Numerous financial situation indices (FCIs) would measure the effectiveness of policies transmitted to the economy:
- Easier FCI: Markets pass on looser policies to the economy through higher stock prices, lower yields and a less expensive currency.
- Tighter FCI: Markets communicate a restrictive policy through lower stock prices, higher yields and a stronger currency.
The existence of sizeable carry trade flows subsequently contributes to a “noise” in policy transmission by loosening or tightening the FCI alone. When a national central bank intends to tighten its policy, large carry trade inflows facilitated by low cost foreign liquidity and foreign exchange swaps undermine such policy stances. Conversely, carry trade unwinding reduces the easing effect of rate of interest cuts.
For asset markets, a weaker influence of policy on financial conditions means higher hurdles in valuing the liquidity risk premium. Money supply points to a liquidity condition, while “transitory” institutional carry trades further alter this calculation. The political and market challenges together point to higher symmetric market volatility. In other words, euphoric booms from inflows that dwarf monetary tightening versus asset crashes from panic-induced unwinding that fuel calls for monetary easing.
