Rapid yen appreciation in this year’s third quarter attracted policy attention when it triggered a brief-but-disruptive volatility surge across major asset markets. The precise contagion emerged quickly. The unwinding of yen carry-trades estimated in the order of several hundred billion dollars ignited a vicious cycle of forced liquidations. As currency gains lifted the repayment costs of yen loans funding non-yen investments, attempts to sell non-yen assets in haste to repay yen debt exacerbated both the yen rally and the local currency assets rout.
Even though market sentiment eventually rebounded and volatility fell, the existence of substantial fair-weather carry-trades — made possible by institutional foreign currency borrowing — attracted policy attention. A mirage of “plentiful liquidity” that comingles “sticky” money supply with “transitory” flows likely overstated the financial system’s resiliency and market depth.
In the context of Warren Buffett’s remark that “You don’t find out who’s been swimming naked until the tide goes out,” transitory liquidity from carry-trades were part of a recent phenomenon that kept markets’ “water level” artificially high and swimmers content, at least until 3Q 2024 demonstrated the fleeting nature of “liquidity-on-loan.”
Fungible Money Sustained Buoyant Asset Prices Despite Rate Hikes
In a subsequent interview, BIS Economic Adviser and Head of Research Hyun Song Shin reflected on the implications of the yen carry-trade unwind. Prior to the volatility episode, asset markets were recipients of inflows from institutional currency borrowing, commonly known as FX swaps. Such swaps bridges sources of cheap liquidity — like Japan — with markets of higher-yielding assets — like the United States. Amid rising FX swap flows, the yen carry-trades gradually evolved from retail investors in Japan putting yen savings into higher-yielding foreign currencies to market-moving institutional “yield-seeking” flows.
Figure 1.
While FX swaps originally served the goal of currency hedging, Shin noted that financial uses of the FX swaps to convert borrowed cash into foreign currencies now represent the lion’s share of this market. Thus, institutions “not constrained by the funding currency” can source liquidity anywhere that is economic to do so, and FX swaps “project” these funds from one market to another, potentially drowning out local monetary measures and market signals.
Shin proposed that if money is already “fungible across currencies” in the current system, then such borderless money erodes the importance of local money supply managed by national central banks. This also rationalizes the puzzling coexistence of high interest rates and buoyant asset valuations. If money supply is tight in the United States but loose in Japan, FX swaps can turn cheap liquidity under BOJ’s easing regime into “fungible dollars” to buy US assets and erode the effect of Fed tightening.
This also explains the 3Q 2024 volatility spike and subsequent risk sentiment rebound seen in Figure 2. Both did not coincide with material changes in U.S. domestic liquidity conditions. For carry-trades inject or drain “transitory” liquidity unrelated to domestic liquidity conditions under the Fed’s purview.
Figure 2.
Borderless, Flighty Liquidity Complicates Policy Transmission and Heightens Market Volatility
Under contemporary central bank frameworks, asset prices are key to monetary policy transmission. The state of risk appetite in equity and corporate debt markets, short-term and long-term interest rates, and currency valuations act as central banks’ conduit to influence activities in the real economy. Numerous financial conditions indices (FCIs) would measure the effective policy stance transmitted to the economy:
- Easier FCI: Markets relay looser policy to the economy via higher equity prices, lower yields, cheaper currency.
- Tighter FCI: Markets transmit restrictive policy via lower stock prices, higher yields, and stronger currency.
The existence of substantial carry-trade flows therefore adds “noise” to policy transmission by easing or tightening FCI on its own. If a national central bank intends to tighten policy, large carry-trade inflows enabled by cheap liquidity abroad and FX swaps erode such policy stances. Conversely, a carry-trade unwind reduces the easing effect of rate cuts.
To asset markets, weaker policy influence on financial conditions implies greater hurdles to assess liquidity risk premium. Money supply suggests one liquidity condition, while “transitory” institutional carry-trades further modifies that calculus. The policy and market challenges together suggest higher symmetrical market volatility. In other words, euphoric rallies from inflows that eclipse policy tightening vs. asset routs from panic-induced unwinds that fuel calls for policy easing.
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