Breaking The Bank

In “One Trade To Rule Them All,” I characterized the yen’s worst year on record as the quintessential example of how 2022’s macro cross-currents have conspired to upend markets. The yen, I wrote, encapsulates the macro zeitgeist.

I also flagged a paradox. In better times, dollar-yen rallies were risk-on events. Not so currently.

The free-falling yen is indicative of the perils associated with central banks sitting idly by in the face of rampant Fed tightening. In the Bank of Japan’s case, domestic monetary policy isn’t just passively working to undermine the currency, it’s doing so actively — the BoJ is conjuring yen to defend a cap on 10-year government bond yields. That’s doubly bad for the yen: It’s aggressive easing when the Fed is aggressively tightening, and it also means that on any day when JGB yields are near the upper-limit and US Treasury yields are rising, rate differentials will move in favor of the dollar.

This wouldn’t be extremely problematic under less onerous circumstances. Indeed, it may not be problematic at all if this weren’t 2022. A weaker yen helps exports, helps ameliorate Japan’s deflationary quagmire and should send a risk-on signal to markets. Currently, however, the collapsing yen is contributing to a terms of trade shock amid elevated commodity prices, and it’s not clear the Japanese public (unaccustomed as it is to inflation, any inflation) will accept price growth that’s even a semblance of meaningful, let alone the kind of rampant inflation seen across other advanced economies. Effectively, the US is exporting stagflation. Japan is one (of many) recipient(s).

In addition to the fundamental story, the optics are bad. Markets often exhibit a visceral aversion to extreme moves, and the yen’s move is extreme.

All of that explains why rapid yen depreciation is a source of consternation and why, when the currency recovers, markets may be inclined to breathe a sigh of relief. Friday’s move (lower) in USDJPY helped bolster risk sentiment, for example, both because it facilitated broad dollar weakness and improved worsening optics.

Make no mistake, this is a big deal. In a recent note, Deutsche Bank’s Aleksandar Kocic suggested, as I did Friday, that the fate of risk assets for the remainder of the year hangs in part on the relationship between US real yields and the yen.

“The June spike in real rates caused a panic selloff in risk assets and FX,” Kocic wrote, noting that “the sheer intensity” of the spike in reals “emerged as a dominant force that temporarily overwhelmed all other factors [leading] other assets [to] develop strong correlations with real rates during that time.”

The figure (above) shows the yen effectively behaving like a risk asset — falling precipitously with rising US reals.

“In our view, the remainder of this year is likely to end up being a replay of the June episode in slow motion,” Kocic went on to say. “Based on that experience, we believe we can anticipate the mode of the market’s reaction — a stronger USD (relative to currencies with inactive central banks) and weaker equities (and credit) in the US.”

The figures (below, from Kocic) show what he described as the beginnings of a “structural break” in the relationship between the S&P and USDJPY.

“In this channel,” Kocic said, the correlation between US equities and dollar-yen could be negative. “The history of their realized correlations” shows a “rapid dive” beginning this summer, he remarked, referencing the figure on the right (above).

This mode of market functioning is obviously contingent on Haruhiko Kuroda’s obstinance. Kocic was more diplomatic. The continuation of these dynamics is predicated on a scenario “where the BoJ remains accommodative and does not pivot,” he said.

If the BoJ does pivot (perhaps under pressure from the finance ministry or the prime minister), the key consideration will be what that pivot looks like. The preferred option is probably a widening of the band which allows 10-year yields to rise beyond 0.25%, but with a commitment to cap them at some higher level. The problem with that approach is that markets, smelling blood, would immediately drive yields up to that level, forcing Kuroda to defend it. Worse, there’s some risk that the upward pressure on JGB yields would spill over — that bunds and gilts and Treasurys would inherit the selloff. With JGB yields still capped, just at a higher threshold, widening the band could boomerang back to Kuroda if JGB-inspired rate rise in other locales ends up perversely increasing the rate differential between Japan and other developed markets, thereby piling still more pressure on the yen. The stauncher Kuroda’s defense of the new cap, the worse for the currency.

At that point, markets would be on the cusp of achieving the impossible. Kuroda would be on the ropes. Within days, market pressure would effectively break the bank. Not in the sense that the BoJ would be broke (that’s a philosophical impossibility), but rather in the sense that they (markets) would achieve a forced abandonment of yield-curve control. At the risk of overstating the case, the blow to the BoJ’s credibility would likely be fatal. The RBA was forced to abandon its own YCC regime late last year, and while that was indeed a devastating embarrassment, the RBA isn’t the BoJ. It can recover precisely because (with apologies) nobody outside of Australia cares all that much. Yes, traders and investors asked all kinds of uncomfortable questions about the RBA’s credibility, but nobody seriously questioned (or perhaps I should say “nobody who’s taken seriously questioned”) the Aussie as a viable currency or suggested the bank should be disbanded for running a failed Ponzi scheme. By contrast, “Oh well, water under the bridge” won’t work for a BoJ that’s forced out of YCC. Such an outcome would be an unmitigated disaster.

Given that, some argue the BoJ, if and when it does pivot, would be far better served to simply scrap YCC altogether, voluntarily, overnight, effectively telling markets, “You can’t fire me because I quit.” That’d create a grievous credibility deficit, but “grievous” isn’t the same as “fatal.”

However, there are problems with that too, not least of which is that scrapping YCC in that fashion could trigger an outright collapse in JGBs. In addition to raising serious questions about the bank’s balance sheet, the consequences for the yen would be a total unknown. Initially, the currency would likely stage a wild rally predicated on the knee-jerk adjustment (higher) in Japanese yields. After that, though, traders would need to address a question that everyone would rather avoid pondering: What would the return of real price discovery mean for JGBs, especially in the context of a moribund market where the largest holder’s credibility is in doubt?

That sounds like a narrow question, but in many ways, it, like the yen in 2022, encapsulates all of the existential policy questions raised by a dozen years spent in what Deutsche’s Kocic has described as a “state of exception.”