14 Aug 2024
Jonathan Platt, Head of Fixed Income
When mainstream national newspapers start writing about the yen carry trade you know its impacting mortgage rates, shares and pensions – the stuff most people care about. So it was last week.
The background to the sell-off in equities we saw last Monday goes back some time. Money has been flowing consistently into US equities, particularly the Magnificent Seven, making them look like a sure one-way bet. In the process it became a pretty crowded trade. However, unlike financial bubbles that have plagued markets for centuries, the best of these companies are experiencing tremendous positive cashflows. The question is about what price multiple to put on future earnings – which is very different from who will pay a higher price for a tulip or the latest new issue with ‘dot.com’ in its name (1630s and 2000 respectively).
The next component part is the Japanese yen. Coming out of the Great Financial Crisis, the yen was a strong currency, with one US dollar buying as few as 76 yen. Fast forward to July 2024 and that one US dollar bought 162 yen. So why has the Japanese currency been so weak in recent years? The answer is ultra-low interest rates as the Bank of Japan (BoJ) battled deflation and a stagnant economy. Whilst major central banks around the world were putting up interest rates in the post-Covid world, to combat inflation, the Bank of Japan was acting in a different way, still buying government bonds and suppressing yields. Again, it looked like a one-way bet: to borrow cheap money in a weak currency. Better still, invest the money in profitable strategies – like equities. Two big beneficiaries were US tech and Japanese exporters, the latter helped by a depreciating yen. One-way bets usually encourage over-exuberance and leverage.
The next element is more macroeconomic. Recent months have seen a shift in relative economic performance. The US has shown signs of slowing, with implications of lower interest rates soon. Conversely, the Japanese economy has witnessed higher inflation than expected, culminating in the Bank of Japan raising interest rates. On the face of it these are really small relative shifts but contributing to significant falls in shares – particularly in Japan and US tech – and a material rally in the yen. Equity market volatility, as measured by VIX, shot up last Monday, a reading only surpassed in the last 20 years by the 2008 financial crisis and Covid – not bad for a 0.25% move in Japanese interest rates.
Not surprisingly, government bond markets have been a beneficiary of the equity market sell-off. US treasury 10-year yields finished the week below 4%, a rise of 15bps from last Monday’s low but still 25bps lower over two weeks. A similar pattern played out in other markets. Yields on 10-year gilts finished at 3.95%, a rise of 12bps but 15bps down on a fortnight whilst 10-year German rates closed just above 2.2%. Credit spreads widened in sympathy with other risk assets. In sterling, non-gilt indices were 4-5bps wider whilst the move out in high yield spreads seen last Monday was partially reversed in the latter part of the week as equity markets stabilised.
There are now lots of cuts priced in the US interest rate curve. Unless there is a renewed bout of weakness in equities these assumptions look overbaked. In our government bond strategies we have been cutting back on long duration positions – just as we did at the beginning of the year when investors were being too optimistic on rate cuts. We think there we will better opportunities to extend duration as bullishness is pared back.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.