The Last Look…
Posted by Colin Lambert. Last updated: August 13, 2024
Much happen while I was away? Apart from a global market meltdown of course? Amidst the bloodletting in markets last week, yet another generation learned the lesson that carry trades blow up from time-to-time, but there were also remarkable echoes of a previous event in FX.
A couple of people tried to penetrate the shield I put up in Fiji by messaging me – apologies for not coming back but I wasn’t a) willing to risk the wrath of Mrs L; and b) put my book/cocktail/snorkel down – suggesting that the structure in FX creaked. I am not sure I agree with that, although I would certainly agree that it was actually the FX market – specifically the Bank of Japan – that kicked the mayhem off.
Several people think that the 12 big figure move by USD/JPY either side of the weekend signalled that markets couldn’t cope, but if you look at the volume numbers from the platforms, I would argue things seemed to work relatively smoothly. I have talked with one trader who lost pricing for a period of time as the technology struggled, but that seems to have been an issue with one provider, other than that, people could get a trade done if they needed to. Not for the first time I find myself writing, just because you don’t like the price, doesn’t make it a ‘bad’ one – Trading 101 states that when the smelly stuff hits the fan, any bid is a good bid.
I was also amused by those who tried to claim the move was “unprecedented”. It’s not – and sorry to get old school on you again, but there were many still in the market today, who were there in 1998 the last time things went pear-shaped in the yen. In fact, the two events are remarkably similar in nature – and there are, perhaps, indications of how this current phase will play out.
In 1998, the US Federal Reserve joined with the Bank of Japan to intervene to stop USD/JPY going north – it was rumoured to be a defence mechanism ahead of President Clinton’s meeting with China, which was making noises about devaluing to remain competitive with Japan – but emerging market turmoil and the start of the Asian crisis were also factors. The numbers are insightful.
Firstly, as a great indication of how the FX market has grown, last month the BoJ sold something like $62 billion to knock USD/JPY down – initially – by four-to-five big figures. In 1998, the Fed sold $833 million (the BoJ about $2.5 billion) and knocked USD/JPY down…about four big figures!
More interesting, however, is the wider scenario that played out. This year the yen has been weakening in the face of the increased interest in carry, and several attempts by the Japanese authorities failed to stop it – at least at first. In 1998, the yen weakened from around the 130 mark to around 144 – in spite of several rounds of intervention from Japan. Even after the initial shock of the Fed intervening in 1998, the combined intervention in June saw the pair fall from 142 to the high 137s, the yen drifted lower again, and with USD/JPY hitting 148 in the third quarter of the year.
USD/JPY can move aggressively and this retracement may not be over, but at the same time, fears of a market structure failure are probably no different to 1998 – they shouldn’t exist
This year, after the shock of the US inflation print and the BoJ’s opportunistic intervention “with the wind”, there was no serious further decline in USD/JPY as investors continued to buy the dip for carry. The problem was there was no bounce and increased nervousness – exacerbated by the BoJ’s monetary policy tightening – and thus we saw the sharp drop to 142 before the rebound to 147.
We sit, therefore, in a similar position to 1998. We have had a mini-shock to the system which has cleared out the weaker positions, there has been a stabilisation and everyone is scratching their heads.
So, what did happen in 1998? Well, the Asian crisis went full-blown and there was a run to safety, which did not, strangely, include the dollar; and within four months of the US intervention, USD/JPY had fallen from its post-intervention peak of 148, to 112. All of which leads me to say that far from “unprecedented”, this may only be the start.
From a market structure perspective, it will be interesting to see how it would hold up if we did see an extended run on the carry trade. Clearly the amounts involved in the carry trade are much larger compared to 1998, but then so is the size of the overall market. In 1998, spot ADV was $568 billion, in 2022 it was $2.1 trillion – and it has grown further since then. What has changed is the risk absorption abilities of the market, and this is where things could get really interesting. Not only were there many more banks trading back in 1998, but they had risk limits. Of course, none were willing to stand in the way of a runaway steamroller, so the lower risk limits of today’s LPs may be meaningless, but what would be interesting – in a real blow out – is whether they would continue to quote aggressively? Recent history suggests not, but they would continue to quote – just as they did in 1998.
The comparisons with 1998, therefore are valid on all counts I would argue, and may be worth noting. The market can move aggressively and this yen retracement may not be over, but at the same time, fears of a market structure failure are probably no different to back then, they shouldn’t exist unless there is a major technology failure, which can happen at any time. The fact is, there will always be a price, it’s just a question of not caring whether you like it or not.
