Decoded: How did a safe-haven asset fuel a stock market crash?
Before we get into the details of the ‘Yen Carry Trade’ phenomena, let us understand what exactly is a safe haven asset.
Imagine your government just announced a Covid19 induced lockdown. What would you do next? Would you prefer buying a car during the lockdown or focus only on essential groceries? Assuming rationality among the readers, you’d prefer buying groceries over cars!
This is exactly what safe haven assets are. In simple terms, safe haven assets are those assets which do well even during a crisis.
1. Safe Haven Assets- An Introduction
As talked about earlier, safe haven assets are those assets that tend to increase in value even during an economic or financial crisis. Basically, they are the ‘groceries’ of the financial world. These are generally those assets which have low risk and hence allow investors to diversify their investments and avoid major shocks during a market crash.
Investors across the globe consider many assets as safe haven such as gold,
Bonds issues by the governments/ central banks of developed countries, stocks of companies selling essential items i.e. the Defensive stocks and even currencies like the US Dollar, Japanese Yen and the Chinese Yuan.
The whole idea behind the ‘Safe Haven Assets’ theory is that such assets have very small or maybe no correlation with the stock markets. In layman terms, you won’t stop buying food if the market crashes or you won’t stop wearing jewelry if the market crashes or the US government won’t default on its debt even if the Dow Jones crashes. Hence, even in the worst case scenarios, such asset classes tend to give positive returns.
2. The ‘Law of One Price’
The Law of One Price is a very interesting theory and also essential to understand how traders earn some X% return without taking on any possible risk. It basically states that two similar assets should sell for the same price in all the markets; or the absence of such equality would lead to risk-free returns.
Imagine that your favorite car sells for $50,000 in Market#1. Whereas, the same car sells for $51,000 in Market#2. As a buyer, you’d prefer buying only from the first market, assuming the transaction costs in both the markets is equal. However, as a trader you’d do something different! In simple terms, you’d buy the car from Market#1 and simultaneously sell that car in Market#2. This transaction allows you to earn a $1,000 return, without actually taking on any risk.
A similar thing can be (and is) done in the financial markets, however in an even more efficient way through short-selling; that’s a story for a different day!
3. The ‘Yen Carry Trade’ in 2008
Going by the definition of carry trades, traders borrow funds in currencies with lower interest rates and invest the proceeds in those with higher rates. Hence, the primary reason for borrowing in Yen and investing in the US was the interest rate differential. Japan had very low interest rates during the first decade of this century whereas the US had higher. This allowed the traders to borrow money at cheaper rates and invest in markets with higher ones, thus allowing them to earn profits at virtually no risks (but not forever!). Confusing, right?!
A simplified example of the YCT-
Let’s say Mr. X is a trader for an investment bank based out of Wall Street. In the year 2002, he sees the interest rate disparity between Japan and the US. So he borrows money in Yen at hypothetically 1% interest rate and invests in US’ Treasury Bills that yield hypothetically 5% for the same period. This allows the trader to earn a risk free return of 4%, assuming no currency movements for the sake of simplicity. Now, the trader realizes that instead of sticking to the US T-Bills that yield 5%, he could invest in risky mortgage bonds, that hypothetically provide returns of around 15%, for the same 1% loan in Yen. This allows the trader to earn a risk-free rate of 14% against the 4% in case of T-Bills.
Again, why was the trader able to earn returns in excess of his loan interest rate? Simply because there was a vast difference in rates in the US and Japanese markets, which eventually got reflected in every possible security, right from government bonds to risky mortgage bonds. And why do we say ‘risk-free return’ for T-Bills? Because the US government never defaults.
So, what was Yen’s role in the market crash?
The 14% risk-free return is based on the assumption that the risky Mortgage bonds do not default. But what if they did? Or, what if the interest rate differential between the US and Japan came down to 0%?
This is exactly what happened!
The risky bonds started to default and the US Fed reduced interest rates in a span of months. So due to defaults and no risk-free return for traders raising funds in Yen, they started selling off their investments in mortgage bonds and later in T-bills & equity markets. This led to a ripple effect, causing more and more traders to square off their positions and dump their shares/bonds into the markets, leading to one of the greatest market crashes ever!
Closing Thoughts…
Interestingly, the Yen Carry Trade was not limited just to the 2002–2008 period. Rather it began around the early 1990’s due to the easing policies by Bank of Japan and is still a prominent practice by the largest investment banks, not only through Yen but also through Euro i.e. a Euro Carry-Trade. According to a report by Deutsche Bank, US investors were able to earn a 2.9% return through such carry trades in 2019. Also, after the March 2020 crash, Yen slumped to a 3-year low against the dollar within days but also rose the most since 2013 in a single day following the news of an economic stimulus by the US. Any carry-trade strategy thrives only in calm currency markets, whereas it is basically impossible to earn ‘safe’ returns in case of volatile markets. Plus, recently the strategy suffered from declining liquidity in the forex markets.
The Yen Carry Trade might sound like a cake walk, but in reality it isn’t!
