Earlier this month, world financial markets experienced a sharp increase in volatility, stock indices declined, and U.S. Treasuries jumped in price with yields declining. Many analysts pointed to the latest U.S. jobs data, with the unemployment rate increasing to 4.3%, a disappointing increase of jobs of 114,000 for July, Institute of Supply Management Manufacturing print coming in at a reading of 46.8 well below estimates and indicating contraction, and the employment component at 43.4, its slowest point since 2020. All of these were contributing components to the market swoon.
Another factor that was mentioned is a little more complicated, the unwinding of the yen carry trade. The yen is the Japanese currency. In basic terms, the carry trade is when an investor shorts the yen or borrows in yen from a Japanese firm, sells the yen to convert to U.S. dollars, and then buys U.S. Treasuries. Given the difference in interest rates, this has been a popular trade and would work so long as the yen does not strengthen against the dollar. Early in August, the Bank of Japan increased its target interest rate to 0.25% from 0.10%, and hinted at further increases. The U.S. Federal Reserve has hinted at cutting short term U.S. interest rates as soon as its next meeting on September 18. Such a move, although relatively small, could make such a strategy less profitable. The investor would then unwind the trade, selling the U.S. assets and dollars and buying yen to repay the loan. If such a trade is large enough, it can cheapen the dollar and increase the yen, making the original trade even less profitable. It may even create a bit of a snowball effect in currency markets. There were also indications that local Japanese investors had borrowed at very low interest rates and invested the funds in higher yielding domestic assets. With funding costs increasing, the domestic investor may be unwinding its trade as well, contributing to an almost 12% decline in the local stock market in Japan.
There are many factors that influence the currency markets and differences in the exchange rates of separate currencies. A higher interest rate available on a nation’s debt instruments can attract investors and drive up the value of that nation’s currency. A country’s foreign reserves can have an impact as well. A country’s central bank can hold a variety of assets, including foreign currency, to facilitate international commerce. These can be bought or sold to influence the value of the local currency as well.
Any investment entails some risk, which can take several forms. Investing in foreign financial assets can expose an investor to that nation’s financial system. There is a preference for the currency of a country that is stable, has a reliable regulatory system and transparent financial transactions. This may inhibit investment in emerging markets. Inflation is another factor. If inflation rates are high, this will depreciate the value of that country’s currency, making its assets less attractive to investors. Trade policies can create demand for the local currency and greater openness can create increase demand. But a one-sided relationship might only be made up by an increase in local taxes or greater debt.
None of these factors are necessarily isolated and there is significant interplay between them. For the U.S., its currency operates as the world’s reserve currency with large amounts of trade and commerce conducted in U.S. dollars. The dollar has strengthened relative to other currencies. In part this is due to the Federal Reserve keeping interest rates higher for longer. In the post-pandemic economy, the U.S. has out performed other countries, creating additional demand for U.S. assets. Trade has been a point of tension and irritation among global trading partners and politics have entered this equation as countries have adopted some protectionist trade policies.
