Risk of flash crashes in markets is rising as Japan does its own thing

The US Federal Reserve Board is about to announce its first rate cut in 4½ years. With one notable exception, the world’s major central banks will be simultaneously loosening monetary policies that have been kept tight since the post-pandemic inflation breakout in 2022.

The Fed, the European Central Bank, the Bank of England and the Bank of Canada are among the central banks cutting interest rates and backing out of quantitative tightening – allowing bonds and other securities they bought to pump liquidity into their systems during the pandemic to mature without reinvesting the proceeds.

The Bank of Japan (BoJ) stands out as the only globally significant central bank lifting interest rates and planning to tighten its monetary policies by scaling back its massive purchases of bonds and other assets.

Diverging policies: Christine Lagarde, president of the European Central Bank (left), Bank of Japan governor Kazuo Ueda (middle) and Fed chair Jerome Powell at the Jackson Hole economic symposium last month.Credit: Bloomberg

The BoJ meets this week – its two-day meeting ends on Friday – and while it’s not expected to hike rates yet again, having raised its policy rate by 25 basis points in July, bets are for another increase before the end of the year as its monetary policies head in the opposite direction to its peers.

The Fed’s move – expected to be the first in a series of rate cuts that could result in the federal funds rate (the equivalent of the Reserve Bank’s cash rate) being cut by up to 250 basis points by the end of next year – will be a watershed moment for global monetary policies, given the bank’s pre-eminent position and its influence over the global economy and financial markets.

Since March 2022, the federal funds rate has soared from its pandemic nadir of near-zero to 5.33 per cent, where it has held since July last year.

The divergence between what the Fed and other central banks are doing and what the BoJ appears likely to do has the potential to create flashpoints within the global financial system.

The Fed’s balance sheet swelled from just over $US4 trillion ($5.9 trillion) before the pandemic to almost $US9 trillion at its peak in March 2022. Then it began its quantitative tightening program and shrunk it to about $US7 trillion today.

When that balance sheet run-off is combined with the expected rate cuts, the Fed will be significantly easing monetary conditions in the world’s biggest economy.

The divergence between what the Fed and other central banks are doing and what the BoJ appears likely to do has the potential to create flashpoints within the global financial system.

Indeed, it already has. In August, weak job numbers in the US, which increased the likelihood of a rate cut, ignited chaos in global markets. Sharemarkets around the world were heavily sold off, commodity prices slumped, bond yields tumbled and there were wild fluctuations in currency markets.

That jobs report, which suggested the US economy was slowing more rapidly than expected, roughly coincided with the BoJ’s decision a few days earlier to lift Japan’s interest rates and foreshadow the winding back of its decades-long purchases of government bonds.

It was those two events coinciding that injected enormous volatility into the markets, primarily because for years, but particularly in the past three or four years, hedge funds, other institutions and even Japanese retail investors have been pursuing an increasingly crowded trading strategy.

They had borrowed cheaply in Japan, where, because of the ultra-loose monetary policies the BoJ had pursued since the 1990s, interest rates were ultra-low and the yen weak, and then used those funds to invest in higher-yielding assets, whether they were currencies, bonds or equities.

Popular recent trades involved using yen-denominated debt or taking short positions against the yen (betting on further falls in the Japanese currency) and acquiring exposures to the greenback, the Mexican peso or America’s high-tech stocks.

The sudden compression in the bond spreads between Japan and the US ignited a panicked unwinding of at least some of those trades, probably the more leveraged of them.

The actual scale of those “carry trades” isn’t known – they aren’t captured by any of the databases – but there are guesstimates that they could total at least $US250 billion, and possibly far more.

After the August meltdown, markets stabilised and then returned to “risk-on” mode, albeit with a brief shudder earlier this month, again after weak jobs data. As rates in the US and Japan continue to diverge, however, the potential for more trades to be flushed out will loom larger.

It may not be just the yen-denominated trades that cause angst. The shifts in monetary policies now occurring around the world are, given how tight and stable the settings have been over the past year or more, creating the potential for something less obvious and more unpredictable to occur.

In the Bank for International Settlements’ (BIS) latest quarterly review, issued this week, there is a significant discussion of carry trades. The bank’s head of monetary and economics department, Claudio Borio, said the extreme volatility in August wasn’t the first, and wouldn’t be the last, episode of turbulence in markets.

“It is part of the bigger picture – the inevitable withdrawal symptoms that markets suffer as they transition away from the extraordinary period of exceptionally low interest rates and ample liquidity,” he said.

In its report, the BIS said the “crowdedness” of hedge fund strategies had combined with high levels of leverage to “set the stage” for the amplification of stress and cross-asset spillovers. It cited statistics that showed multi-strategy funds had entered August with leverage ratios, once their derivative positions were included, of 14:1.

As the bank said, when many funds are pursuing strategies that expose them to the same risk factors, that crowdedness and leverage amplifies the risk as they scramble to exit their exposures.

It referred to the more recent flare-up of financial market volatility earlier this month, which it said underscored how “hypersensitive” markets had become to growth-related news surprises.

The yen carry trades aren’t a recent phenomenon – they have been around for the decades Japan’s economy has spent in the doldrums. But the available data does suggest that there has been an acceleration in the volume of trades recently.

BIS data shows a 21 per cent increase in Japanese banks’ foreign lending to $US1 trillion over the past three years. The foreign lending data is a crude proxy that reflects the direction, if not the volume (because it would include more conventional loans), of carry trade activity.

While August’s turmoil probably wiped out the riskiest of those trades, there is little doubt within financial markets that there are still a lot of them out there.

The yen has been appreciating against the US dollar. It has strengthened from its weakest levels in nearly 40 years – in July this year – to its strongest level since July last year.

With foreign exchange analysts predicting further gains well into next year as the BoJ continues to increase rates, those remaining trades will come under intensifying pressure.

As Borio indicated, as the other central banks continue to work back from the high watermarks of their post-pandemic monetary policies in line with easing inflation rates, the potential for more bouts of turbulence rises.

The yen carry trade is the most obvious source of further volatility, but given how opaque much of the hedge fund and other non-bank activity in markets tends to be, it almost certainly won’t be the only one.

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