Hyun Song Shin on How Big the Yen Carry Trade Really Is

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1:25Hello and welcome to another episode of the Oddbots podcast. I'm Traci Alloway. And I'm Joe Weisenthal. Joe, do you remember the carry trade unwind? So the carry trade, what's the deal? Basically, people borrow yen and buy Nvidia, and then the yen went up, and then the trades didn't work as well? Well, that was one aspect of the commentary. That's like the Twitter version of what's happening. Yeah, but I think actually, okay, so we are recording this on August 23rd. The carry trade unwind happened, what was it, two weeks ago? Two or three weeks ago? It feels like a lifetime ago. And it's kind of remarkable how quickly it faded into the background with the market rally and the recovery.

2:09But the conversation at the time was that there is this carry trade, which involves borrowing in lower yielding currencies or lower interest rate currencies, such as the yen, and then investing in higher yielding assets like, in theory, U.S. technology stocks. Or U.S. treasuries. Yeah. But the problem is that some of the discourse around this has been, I've kind of been offended by some of it. I've seen things out there basically implying that the entire financial system is imploding because the carry trade is unwinding. I mean, it's really crazy how quickly that disappeared because there was that mega vol spike.

2:51And we were talking historically high levels on par with some of the financial crises. And then the expectation was like, at a minimum, this takes a while to settle down. Yeah. And it settled down in about 15 minutes, in a day and a half. Absolutely. And so what was that? What is the carry trade? Because there is this sort of caricature version that is out there. Who actually is engaging in it? Is it still going on? Many questions in my head remain unanswered. Yeah. And one of the big ones is just how big is it actually? And one of the funny things that happened a few weeks ago was people were basically looking at all the yen denominated assets in the world, like the entire Japanese banking system and saying, this is the carry trade.

3:33This is how big it is. Okay. Let's clear up some misconceptions. We are going to do that right now. And I am so pleased to say that we do, in fact, have the perfect guest. We are recording here in Jackson Hole, Wyoming for the Kansas Fed Economic Symposium. and we have once again run into one of our favorite odd lots guests an expert on this exact topic we're going to be speaking with hyun sung shin he is of course the economic advisor and head of research for the bank for international settlements and he's been looking at the carry trade for years now so hyun he actually knows what he's talking about yes hyun thank you so much for coming on odd lots thank you for having me again it's so good to see you again absolutely beautiful Jackson Hole.

4:17Absolutely. I'm so glad we could make this happen. And I am kind of glad that the carry trade unwind happened just a couple weeks ago. Something to talk about. Yeah. And you happen to be here and you're an expert on this. So let's start with something very basic. What is the carry trade? The carry trade is a financial transaction where you borrow a currency with a low interest rate and then invest the proceeds in other higher yielding assets. And I think the classical version of a carry trade would be where you borrow. I mean, it's basically a currency transaction where you borrow a currency with a low interest rate and invest in a higher interest rate currency.

5:00But the way that the carry trade was portrayed in the recent discussion, I think that was described in much broader terms where you were going into all kinds of different assets. And Joe, as you describe, It was a very short-lived episode of stress, but at the time it was pretty intense. And I think we can now look back on it with some relief that nothing broke. There was no financial market dysfunction as we saw during the March 2020 episode, for example. So we're now back to something which looks more normal, but I think we should try and learn some lessons from that episode. Absolutely. Absolutely.

5:40And obviously, there's a lot of that still out there and much to be learned. Before we even get to the future, I mean, you described what a sort of classical carry trade is and what we're talking about. And I joked in the beginning, it's like, oh, borrow yen cheaply and then buy Bitcoin or whatever. But actually, when we talk about this, who are the actors involved? Is it speculators who see a spread? Is it institutions like insurance companies? et cetera, that have some sort of larger structural reason? Who actually is engaged in such type of activities? It's really the whole ecosystem, if you like.

6:19I think the main actors would shift from time to time. I think one way that we could try and approach this question is, as Tracy alluded to earlier, how large is this? What's the most reliable way of trying to gauge this? Now, one way of doing that is to look at the on-balance sheet lending in yen. And at the PIS, as you know, we've received data from our member central banks. We collect it and then we distribute it and we've been doing it since 1977. So in a way, we are the curators of this very important banking data of international banking business. So one thing that we can look at in that data set would be, what is the cross-border lending that is yen denominated?

7:04Or even if it's not cross-border, what is the yen denominated lending as a foreign currency? So even if the loan is booked in a country outside Japan, it's in yen and it's in foreign currency. Now, one of the things that I put in the tweet thread is that if you look at that number, there was clearly a very sharp increase in yen borrowing as foreign currency in 22, 23, but it's something like 40 trillion yen. So that's quite large,$270 billion roughly, depending on the exchange rate. But it's not the kind of numbers that we're being banded about in the markets. And not all of that is going to be engaged in yen carry trade.

7:52The other way of thinking about this is how does that borrowing take place? And one thing that is quite interesting is that a lot of the cross-border lending is happening through the inter-office accounts, which is to say, if there's a foreign banking group which has an office in Japan, how much is the subsidiary or the office in Japan lending out to the headquarters in yen? And that turns out to be a pretty sizable chunk of that 40 trillion. It's around 14 trillion would be that inter-office. But much more important than this on-balance sheet is the off-balance sheet transactions. And here the crucial market is the FX swap market.

8:35And FX swaps are where one party would deliver one currency. So if I deliver dollars to the counterparty, the counterparty would give me the equivalent in yen. With the promise that that transaction would be reversed at a set date in the future at an agreed exchange rate. So the exchange rate is fixed at that point. And normally, if I'm a dollar provider, what I do is I provide the dollars, I receive the yen in return, but because I need to repay the yen, I need to keep it in a safe place. So I would park it in a safe, in a yen asset. Just to be clear, typically FX swaps, it's not really a trade per se, or it's not often a trade.

9:18It's more of a hedging activity. So if I have a lot of yen exposure, I want to offset some of that by acquiring dollars and vice versa. Yeah. And that's exactly the use case for a swap contract. But the issue here is if I receive the yen, rather than parking it in a safe place, what if I just sell that yen on the spot market and acquire dollars? Then I have a naked yen obligation, which I will need to meet at the time by repurchasing the yen on the spot market. And that market is pretty sizable. It's around$14 trillion, the swap market between yen and another currency. That's quite a bit larger than the 270 billion that I mentioned earlier.

10:05So as Tracy characterized it, there is sort of a natural hedging need for those sort of swaps. What types of institutions have that need to engage in a the swap market? It's both financial and non-financial. I think typically the textbook case is of a non-financial institution. So if I am an exporter or an importer, I would like to pay for the goods in advance, but then I need to hedge the currency exposure in the meantime until the maturity of that swap. What we've seen though is that since the global financial crisis, It's the financial uses of the FX swap market, which has really grown much larger.

10:53So it's fair to say that it's the financial uses of the FX swaps, which are the lion's share of the FX swap market. And I think it raises perhaps a deeper question, which is if you're not constrained by the funding currency in what you can invest in by using the swap market. In other words, suppose I can only raise funding in one currency. Well, typically that means that unless you have balance sheet mismatches, you would need to invest mostly in that same currency. But through the swap market, you can basically overcome that particular constraint. And what that means is it's much better to think of financial conditions in global terms rather than simply country by country.

11:41because you can always deploy the funding in one currency and invest in the assets of another currency.

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13:18Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market. Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokerage services for U.S.-listed registered securities, options, and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA, and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. It sounds also like it's additional liquidity if you can use FX swaps to bypass, you know, specific currency constraints in terms of funding capacity.

13:56If I was, I don't know, an emerging market exporter and I needed dollar funds, obviously there's a limit to the amount of dollars that I can get in a situation like that. But if I know that I can go into the FX swap market and get that additional liquidity, it presumably expands credit in the overall system. In contractual terms, a swap is completely symmetric because one party is providing one currency in return for the other and vice versa for the other party. But from time to time when financial conditions vary across different currencies, different markets, there is a, if you like, a lead party in asking for that transaction.

14:38And there is a market, if you like, response in supplying it. So let me give you an example. So if I am a, let's say I'm a euro area insurance company, and I would like a globally diversified portfolio, including dollar assets, but most of my obligations are in euros. And so if I were to invest nakedly in dollars, there would be a currency mismatch on my balance sheet. And this is where I would go to the swap market, I would swap the euros into dollars and then I would invest the proceeds into dollar bonds, for example. In a way, that's like borrowing dollars. I mean, the economic rationale is very similar to borrowing dollars in order to invest, but it's not treated as borrowing in the conventional accounting sense because it's a swap.

15:27There is also a countervailing transaction the other way. But you can normally track what's called an FX swap basis to see which direction that transaction is going. So it turns out that typically, normally, it is more expensive to borrow dollars in the swap market than it is to borrow dollars in the dollar money market. And that extra premium is, if you like, the additional price you have to pay in order to access dollars. Now, coming back to the yen story, although most of the time, financial institutions are borrowing dollars in the swap market in order to invest in dollar assets. That's typically the direction of the trade.

16:09This is why during financial stress periods, these FX swap bases spike and then there has to be central bank swap lines to quell, etc. But there's nothing in principle that says it always has to go towards the dollar. If your intention is to engage in a yen carry trade, but through using FX swaps, you could borrow yen and then acquire that yen obligation by going through the swap. And so one telltale sign is what happened to the FX swap basis during this recent episode? And in fact, one of the interesting findings is that the dollar FX basis versus the yen hardly budged. It's actually a very small movement, which is very atypical of a financial stress event.

16:58Yeah. Why is that? Because I would have assumed that the people providing swaps, who I assume are dealer banks of some sort, with such volatility in the currency rate, I would have thought that they would back away from providing that liquidity and so the basis would blow out. So there was definitely a little bit of that, but it was by no means the same magnitude as we saw, for example, in the March 2020 episode. And the reasoning would be that in that case, the, if you like, the party that was driving that particular transaction wasn't borrowing dollars, which needed to be repaid in the scramble for dollars, but rather it was the repayment of yen.

17:42Oh, I see. Okay. So it goes the other way. So actually, so much sort of happened during that But I don't know, this sort of like the mini crisis of July 31st to August 6th of 2024. And it came and went - That should be the official name. Yeah, that's the name of that. So there was a Fed meeting that perceived perhaps to be a little hawkish. Then we got a week unemployment report. Then of course, the yen had been creeping up right now. And we'll probably still be learning more. What is the story that you tell like what actually happened in those six or seven days? that triggered such a move and then triggered such a move that was able to reverse so easily.

18:23What's your basic? What happened that week? Yeah. And clearly, Joe, there was quite a bit of action in the currency markets. But I think what you're referring to is the fact that equity markets were impacted very broadly across the world in a way that you wouldn't have expected if it were a sort of narrow carry trade story. And indeed, I think there is something to that in that probably we're putting too much weight on the carry trade as a key theme of what happened in early August. In that, yes, there may have been the classical carry trades going on where you borrow yen and then you invest in the high yielding currencies.

19:04You can see which currencies fell most in early August, and they were the Mexican peso, Colombian peso, and the rand. So these were the destination currencies for those classical carry trades. But I think it's not really enough to explain why there was this much more broad-based stress, especially in the equity markets. And I think here we have to think about the broader issues to do with how risk is managed, how risk management itself, risk management in the form of loss mitigation also generates some potential for amplification that could actually make things more volatile. So let me explain what I mean by that.

19:49So if I have a value at risk rule that says, if my risk is triggered beyond this VAR level, then I cut my position. That means I sell or Or if I'm lending, I cut my lines, et cetera. From the point of view of the borrower or from the point of view of the market as a whole, that is something that would actually amplify whatever stress that was there in the first place. If I'm a lender and I set margins, or if I'm a CCP, a central counterparty or an exchange, there is a margin that I ask for, the various contracts that I deal with. typically during stress periods, those margins go up. So that's kind of deleveraging.

20:32Now, the way that we deal with risk is precisely to mitigate loss. And there is this spillover effect that goes to the broader market. And I wonder whether we should look back on the events of early August and, if you like, apply that lens to the events back then. So if, for example, I was not borrowing yen and investing in technology stocks, as you suggested. But it's just that within my firm, there is a team that is doing a classical carry trade, but there is also a team that is leveraged to US tech stocks. But one team doesn't know what the other team is doing. So let's say one pod doesn't know what the other pod is doing.

21:18But from the firm's point of view, it looks as if in aggregate that there is a short yen position and the long position in technology stocks. And if that risk constraint is triggered somehow, it's going to have a much broader implication, much broader repercussion through all of the holdings. This kind of reminds me, there used to be that saying about in a crisis, you sell what you can, not necessarily what's most impacted. So it might be that the most volatility is falling in the currency market and in the carry trade, but the thing that you're selling to reduce your risk exposure is something totally different just because you can or because it's easier to do in an extremely volatile environment.

22:03And if you like, it's the risk limits that are triggered. And the way that risk limits work is if the aggregate portfolio is suffering losses, then the risk limits are tightened for all the different assets that you own. And I think there is something that we need to think about in terms of how we can mitigate some of these issues. And going back to the FX swap discussion, the BIS also collects data on FX swaps. We have the six-monthly release of our over-the-counter derivative statistics. And the numbers that I've given you, these are all from our data. It's all on our webpage. I think there is probably more scope for us to have more refined data.

22:47For example, who is the instigator in having the FX swap drawn up in the first place? So who is the lead party? Where is it being booked? What are the sectors that the two parties are coming from? At the moment, we don't have that kind of data. But this is something that the BIS is working very hard to try and assemble. And given the shift away from the very bank-centric system to something which is much more a market-based system, which we have now, I think this is really something that we need to do as a matter of urgency.

23:45The point is you're engaged with your investments and public gets that. That's why they built an investing platform for those who take it seriously. On public, you can put together a multi-asset portfolio for the long haul. Stocks, bonds, options, crypto, it's all there. Plus an industry leading 3.6 % APY, high yield cash account. Switch to the platform built for those who take investing seriously. Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market.

24:43pages of market research into five insights with a click? Do that with Acrobat. Need templates for a sales proposal that'll close that deal? Do that with Acrobat. Need an AI specialist to tailor the tone of your market report to sound real smart in real time? Do that with the all new Adobe Acrobat Studio. Learn more at adobe.com slash do that with Acrobat. So can we actually, I want to go back to your point about, you know, financial conditions being a global phenomenon, because that has been one of the questions here in the US. And there are people scratching their heads, financial conditions by some measures being tight, but spreads being very narrow for credit.

25:21And of course, the stock market having rocketed up. Can you flesh that out a little bit more like this sort of like how we should rethink financial conditions in a world of sort of like easy swapping between currencies on a non-bank basis? Sure, sure. I mean, that's a very, very important issue actually Joe. You know when you look at the typical financial conditions index, let's say you take the Goldman Sachs index which is probably the best known, there are two components there. One is really just about how high are interest rates, how high are yields. There's another set of indicators which measure how tight are the credit spreads, what's the dollar doing, that kind of thing.

26:00And what's really been quite surprising is that even though rates have been raised to quite high levels. So the rates, those indicators that point to how high interest rates are, they've been quite tight. But stock markets, credit spreads, they've been extremely accommodative. And I think one way that we could rationalize this is that if we have a world where essentially money is fungible across currencies, basically what a swap does is to make money fungible across currencies. If I have dollars, I can get yen, vice versa. And in that kind of environment, it's not simply how much the US money supply is, how much the euro money supply is that matters.

26:49It's really about what the global picture is and what are the marginal rates at which one is swapped into the other. And I think one potential explanation for why financial conditions have been so accommodative in spite of the very high rates is that money will flow to the most accommodative section of the money market. And the swap is the instrument that's going to really give you that fungibility. And when we look at the growth of the aggregates, it's been quite rapid. So if we go back to the GFC, before the GFC, the global financial system, it was very much a bank-based system. And the GFC was, in essence, a banking crisis.

27:32And the existing BIS banking statistics covered that really well. In some of my work as an academic, I relied really a lot on the BIS banking data to really document what happened in the lead up to and then the resolution. But since the GFC, we've moved very much to a market-based system where the non-bank financial intermediaries are taking on a much bigger role. And in that world, the banking statistics that the BIS puts out is only looking at a very small part of the overall universe. And increasingly, it's the FX, swap market, and other market-based intermediation figures that we need to keep track of.