Japanese Rates Affect Global Assets

While investors have been consumed with the prospects for a 25-basis point rate cut at the next FOMC meeting, fears of a rate hike from another key central bank put a negative spin on global asset prices this morning.  Bank of Japan Governor Kazuo Ueda said in a speech that the BOJ would “consider the pros and cons of raising interest rates” during its December 18^th-19^th meeting.  In response, Japanese 2-year rates rose to their highest levels since 2008 and the yen strengthened accordingly.  Those developments pressure the popular “carry trade”, leading to risk aversion from leveraged investors.

We wrote about the mechanics of the carry trade on August 5, 2024, when fears of a BOJ rate hike reverberated throughout global markets.  The short version is that it is quite common for hedge funds and other leveraged investors to borrow in low yielding currencies, like yen, and use those borrowed funds to purchase other assets.  Rising rates increase the cost of borrowing while also increasing the value of the borrowed currency against those of its main counterparts.  Those factors could certainly incentivize investors utilizing the carry trade to pare positions.  It is difficult to measure the size of the global carry trade, since many of the positions utilized private contracts, but a 2024 study from the Bank for International Settlements (BIS) estimated that yen carry trades measured about $1.7 trillion, though they acknowledged that is an indirect picture.

Although the moves this morning pale in comparison to those of that day – at that time VIX (the Cboe Volatility Index) peaked over 50 – the lessons of that misadventure were clearly not lost on global investors.  The likelihood for a rate hike had been increasing steadily for the past week before taking another leg up today.  We currently see 76% of “NO” probability for an unchanged BOJ rate on ForecastEx, while Bloomberg estimates about an 86% chance of a hike using overnight index swaps.  Both ebbed at about 20% just 10 days ago.

Likelihood of a “NO” for the BOJ Leaving Rates Unchanged in December

Source: ForecastEx

Interestingly, the moves on the “NO” contract for the BOJ leaving rates unchanged roughly mirror the changing likelihood for a “YES” contract on the FOMC cutting rates by 25bp on December 10^th:

Likelihood of a “YES” for the FOMC Cutting Rates by 25bp in December

Source: ForecastEx

That convergence has probably worked to blunt concerns about the carry trade to some extent.  Concurrently rising expectations for a Japanese rate hike and Fed rate cut gave carry traders an opportunity to shrink positions, though last week’s holiday-thinned volumes in the US alongside rising asset prices probably dampened their desire to do so.  That may be why the overnight bump in BOJ hike probabilities shook markets a bit more than they otherwise might have.  Global bond benchmark yields rose in almost every developed country, with most rising by about 5-7bp.  The US is no exception, with 10-year yields rising by more than 7bp as I type this, though some of the yield pressure is being attributed to hedging an $8bn bond sale by Merck (MRK). 

Stock markets in the US got off to a negative start thanks to weakness overseas.  The Nikkei fell by -1.89%, and while the Euro Stoxx 50 was essentially unchanged (-0.01% to be exact), the German DAX fell by -1.04% as well.  But the “buy the dip” impulse remains intact, and the S&P 500 (SPX) and Nasdaq 100 (NDX) had recovered most of their early losses by noon EST.   Perhaps that was traders’ biggest takeaway from the events of August 2024.

Yet the arguably riskiest asset class – cryptocurrency – remains under extreme pressure today with nary a bounce so far.  Bitcoin and other cryptos plunged after Governor Ueda’s speech but have yet to recover all but a meager bounce from their lows.  Bitcoin is currently down more than -7%, which means that it is outperforming its peers like Ethereum, Solana, and others that are down more than -9%.  Despite – or perhaps because of – their high volatility, traders can more easily access leverage on their cryptocurrency holdings.  If a ripple (no pun intended) in the carry trade causes a move away from leverage in relatively safe assets, like global government bonds, then it stands to reason that heavily leveraged, highly volatile cryptos would see a tidal shift.  That said, it is positive for stocks that they have been able to largely shrug off the pernicious relationship between bitcoin and NDX that pervaded stock markets about two weeks ago.  It’s no coincidence that the relationship peaked just as rate cut expectations began to rise.