As the third quarter of this year ushered in a rapid appreciation of the yen, it caught the attention of policymakers due to the volatile surge it triggered across major asset markets. The aftermath revealed a cascading effect, with the unwinding of yen carry-trades leading to substantial forced liquidations estimated in the hundreds of billions of dollars. This cycle was fueled by the rising costs of repaying yen loans, as well as the rush to sell non-yen assets to settle yen debt, intensifying both the yen’s strength and the decline in local currency assets.
Even as market sentiment eventually stabilized and volatility subsided, concerns lingered over the prevalence of fair-weather carry-trades facilitated by institutional currency borrowing. This illusion of abundant liquidity, blending sustained money supply with transient flows, may have falsely projected the financial system’s robustness and market liquidity.
In the context of Warren Buffett’s analogy about exposed vulnerabilities surfacing when the tide recedes, the transient liquidity from carry-trades played a part in artificially propping up market conditions, only to reveal the fleeting nature of borrowed liquidity in the wake of the events of the third quarter of 2024.
Fungible Funding and Asset Prices Resilient in the Face of Rate Hikes
In the aftermath of the volatility, BIS Economic Adviser and Head of Research Hyun Song Shin reflected on the implications of the yen carry-trade unwinding. The surge in asset markets prior to the volatility was sustained by institutional currency borrowing through FX swaps, linking sources of low-cost liquidity, such as Japan, with markets offering higher yields, like the United States. As the flow of FX swaps increased, what started as retail investors in Japan seeking higher foreign currency yields evolved into institutional flows seeking higher yields.
While FX swaps initially served hedging purposes, they have come to dominate the market as financial tools to shift borrowed funds across currencies. This borderless liquidity highlights the diminishing significance of local money supply managed by national central banks, blurring monetary boundaries and shaping market conditions irrespective of domestic liquidity measures.
This interconnectivity explains the volatility spike and subsequent market sentiment rebound observed post the third quarter of 2024. The carry-trade movements injected or withdrew transient liquidity disconnected from domestic conditions, influencing market dynamics beyond domestic liquidity management.
Borderless Liquidity and Market Volatility Amid Policy Challenges
With asset prices serving as conduits for monetary policy transmission, contemporary central bank frameworks rely on financial conditions to influence the real economy. The existence of substantial carry-trade flows introduces noise into policy transmission, complicating the impact of monetary policy on markets.
The presence of extensive carry-trade inflows stemming from abundant foreign liquidity and FX swaps diminishes the efficacy of national central banks’ policy stances, muddling the transmission of policy signals to markets. Conversely, the unwinding of carry-trades impairs the easing effects of rate cuts, creating challenges for market assessments of liquidity risk premiums.
In sum, these intertwined policy and market dynamics culminate in heightened market volatility, teetering between euphoric inflows diluting policy tightening and panic-induced outflows inducing calls for policy easing.
In Conclusion
The events of the third quarter of 2024 underscore the intricate interplay between borderless liquidity, carry-trade dynamics, and market volatility, challenging traditional policy transmission mechanisms. As investors navigate these complexities, understanding the implications of transient liquidity and carry-trade unwinds becomes paramount in deciphering market signals and anticipating policy shifts.
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