The End Of Easy Money

Just over a couple months ago the Bank of Japan made a simple yet historic announcement: that they were prepared to begin raising their interest rates shortly, perhaps as early as next month. Now admittedly on the face of it such an announcement wouldn’t appear all that groundbreaking—Central Banks the world over change their rates all the time, albeit rarely with such forewarning. But in Japan’s case the decision marks a pivotal moment in our modern financial history.

Japan is the world’s second-largest economy, and Japanese short-term rates had been hovering near 0% for almost six years. These two factors—high liquidity in combination with miniscule borrowing costs—have formed the backbone for a modern economic miracle known as the yen carry trade. But now with Japan preparing for the prospect of raising rates, the miracle is beginning to unravel…and it’s already started wreaking havoc with global markets.

The yen carry trade is a pretty sweet deal by which speculators could borrow money from Japan at well under 1% interest and then turn around and use the funds to purchase bonds or assets elsewhere, pocketing the difference as profit. This ultra-easy money policy was intended to spur Japanese bank investment and bring Japan out of a depression, but that didn’t really happen. Instead the money was used to finance global speculation. And because this “free money” was being distributed in seemingly limitless amounts by a sound industrial nation with deep pockets and a stable currency and rate history, the deal proved too good to pass up for major investment houses, banks, mutual funds, insurance groups, pension funds and hedge funds the world over.

The actual numbers are unfathomable, but we know the BOJ was injecting some $300 billion a day into the system (Zhejiang Online, April 20th), which was about $250 billion over their own stated “required level” of current account deposits. This means the banks were continually hard-pressed to find other uses for 5 or 6 times the money they actually needed, and that excess liquidity went anywhere and everywhere there was a profit to be had. The yen carry trade has bolstered U.S. Treasuries certainly in recent years, but in a highly competitive financial world a few percentage points in risk-free profit is never enough. Thus these funds quickly began to feed more speculative bond, currency, derivative and stock markets. They’ve even provided significant hot-air to inflate the worldwide housing bubble.

But now (to mix metaphors) the gushing spigot is being shut-off as the BOJ ceases rolling over most of their short-term debt. All told, perhaps some $2.5 trillion will gradually have to be repatriated as the longer loans come due (International Forecaster, April 2006). The BOJ is under definite pressure to go slow and to keep the liquidity flowing as long as possible, but a recent Nikkei Financial Daily opinion piece stated the liquidity draining is actually happening quite a bit faster than expected, and hinted therefore that the first rate rise could come in June (Bloomberg, May 9th). This indicates the BOJ may be more anxious to tighten things up than market players would like.

In a world already buckling under financial strain and suffering from high crude oil prices, with rising interest rates in advanced economies, global current-account imbalances, and with the U.S. Dollar seemingly under attack by policies both within and without its borders, the end of the yen carry trade party is bound to bring an unpleasant hangover.