After a long smooth run, markets had a dramatic start to August. It began with monetary policy between the US and Japan unexpectedly converging. The longest-held assumption was that Japanese monetary policy would remain loose indefinitely. After all, Japanese interest rates have been near zero for almost three decades. This policy ensured that Japanese Yen remained stable or depreciated against the US Dollar.
This set-up created the perfect environment for a carry trade. Global investors could borrow in Yen at 0% and invest in assets worldwide, making a neat profit. It cost nothing to service these borrowings. To sweeten the deal, if the Yen depreciated, they made a profit regardless of how their investments performed. So, the trade gained both momentum and leverage. Over time, these leveraged investors became less careful about their investments.
A perfect environment can support careless decisions. But when the environment changes, strategies must adapt. The global market volatility earlier this week is just the beginning. The Bank of Japan has comforted markets by promising not to hike rates in an unstable environment. The real question is can monetary policy exist just to please markets?
“But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons.” – Warren Buffet