Japan's Carry Trade

As Japan and other countries experiment with negative interest rates, the central bankers of the world may get more than they bargained for. Japan is the perfect experiment right now for Americans to watch. It should provide an example of what not to do.

Japan should be the dream of people like Paul Krugman, who think the answer to every problem is to create more money and run bigger deficits. Japan has plenty of that going on.

Japan’s debt-to-GDP far exceeds 200%, which makes Greece look like a fiscally responsible paradise in comparison. Japan has had its digital money-printing machine working overtime, while the central planners continue to push interest rates down.

The Bank of Japan has defied anything called a zero lower bound. Not only is the central bank imposing negative rates on banks, but it has managed to push the 10-year Japanese yield down to about -0.1%. You can turn your money over to the government in order to get less of it back in 10 years.

Negative interest rates only make sense up to the point of it acting as a storage fee. If you wanted to get a safety deposit box to store cash, the bank would charge you a fee for the safety deposit box. And speaking of safety deposit boxes, it is no surprise that sales are up in Japan for personal safes, as people would rather store their own money than pay a fee.

Only in a world of fiat currency and central banking would a negative interest rate exist. Most people would rather have a dollar today than a dollar next year.

Still, the Japanese people are not blameless in this. While the central bank has been buying a majority of the debt lately, Japanese investors have still been buyers of government debt over the years. With all of the monetary inflation and the ultra-low interest rates, it is amazing that anyone would keep buying.

I don’t know if some Japanese investors think it is their patriotic duty to buy their government’s debt, but how long will they keep this up? If the Bank of Japan doubles the money supply again, and if the debt-to-GDP goes to 300%, will that finally be enough for investors to sell? It seems the camel already has too many straws on its back, yet more keep being added.

Japanese Miracle Turns into Disaster

While the Japanese economy is a complete disaster right now, it is still a relatively wealthy country. Japan was considered a miracle in the 1950s and 1960s. After being devastated from World War II, the country recovered — and rather quickly — in becoming an economic powerhouse. If you recall, many people in the 1980s thought the Japanese were going to take over the world, at least economically speaking.

The miracle that happened after the war is called the free market. Japan and Germany both turned to relatively free market policies, which enabled savings and capital investment to quickly grow and create wealth.

Unfortunately, for the last couple of decades, Japan has largely turned against the policies that originally helped it become so rich. Of course, you could say the same thing about the U.S. and Germany as well.

Up until just a few years ago, the Bank of Japan actually maintained a relatively stable monetary policy without a lot of monetary inflation. Many people think Japan has been stuck in deflation for decades, but prices have been rather steady, with only short periods of mild price deflation. It is only deflationary by our standards.

Unfortunately, despite the somewhat sane monetary policy, the government has spent money like crazy. As I mentioned, Japanese investors were willing to buy debt at low rates. This enabled the government to run huge deficits, despite little buying from the central bank in the past.

Under Prime Minister Abe, things have gotten much worse. After taking office in late 2012, he declared that escaping deflation was the greatest and most urgent issue. He has been incredibly aggressive in implementing so-called government stimulus. This has meant even more government spending, along with massive monetary inflation.

For the central planners who think these are the answers to economic ills, we should ask them why the Japanese economy is not booming yet. Do they need to start doubling the money supply every six months? Do they need to implement interest rates further into negative territory?

What Goes Up

One of the consequences (we can’t say “unintended” anymore) of negative interest rates is the carry trade. This may turn out to be an exaggerated version of the carry trade.

A carry trade is when investors borrow money at low rates in order to invest in other assets for higher returns. This strategy is most common when dealing with currencies in the foreign exchange market.

The Japanese could borrow money and put it in stocks or other assets within Japan, and some certainly have. But if you think it is tough to find a good yield in the U.S., imagine what the Japanese people are facing. It would not exactly be a sound strategy to borrow money to buy stocks.

Interestingly, it was recently reported that Japanese investors are suspected of fueling a boom in Australian real estate investment trusts.

And why wouldn’t they? When the government and central bank have created an environment of virtually zero yield, people will get creative in order to find positive yield. Does anyone want to save money for 10 years only to have it earn nothing, or less, over that time?

While Australian REITs are one trend for Japanese investors, we can be sure they are pushing money in all different directions. It is almost surprising that we don’t hear more stories of Japanese putting money into American markets, whether in stocks or real estate.

This is what happens when you get massive monetary inflation, along with low (in this case negative) interest rates. Some people are naturally going to engage in the carry trade strategy.

There has been some volatility in the currency markets. The yen had not been doing well, but it recently had a period of gains with temporary weakness in the dollar.

It is not hard to imagine that the carry trade will build up more over time as rates stay in negative territory. This can be a major problem, as carry trades eventually unwind.

What goes up must come down. What gets wound must get unwound.

What happens when those Japanese investors have to pay back the loans they took out in yen? They will have to convert their assets back into yen. It makes for a more volatile currency market. If the Australian currency were to fall against the yen, this could mean major losses and defaults for some investors.

A Race to the Bottom

Of course, Japan is not the only country with negative interest rates, as this has become a widespread phenomenon across Western Europe as well. And most of the major central banks are engaging in monetary inflation. The one major exception right now is the Federal Reserve.

Still, while we compare currency exchange rates, we shouldn’t lose sight of the fact that we are comparing all fiat currencies that can easily be created by typing digits into a computer. The U.S. dollar is strong right now, but compared to what?

We have been in an environment of low interest rates and low price inflation. Consumer prices have stayed down due to economic fear, as well as a lack of bank lending.

It is easy to get complacent and think things will always be this way. It becomes the new normal. But debt-to-GDP ratios over 200% (and increasing) are not sustainable. Just a small increase in interest rates can change things quickly and dramatically.

Luckily for Americans, despite the major problems in the U.S., Japan is worse in almost every way. The Japanese will face the same crisis with retirees and massive unfunded liabilities. The government debt there is far worse, which more than offsets any good saving habits by some individuals. And the distortions from the monetary policy have to be massive.

When Japan blows up, we can only hope that the economic central planners will be discredited to such a large degree that Americans refuse to go down the same path and put a halt to these insane policies.

Still, we can’t be certain of any of this, so I am not betting on higher interest rates yet. That will be a play for another time. It is a time to sit tight and preserve wealth. As always, this should include owning some gold and silver in case the Fed decides to follow the lead of the Bank of Japan with endless digital money printing.

Until next time,

Geoffrey Pike for Wealth Daily