Sensex reclaims 21k: Why yen carry trade will ensure ‘easy money’ continues

1000-yen-natsume-sosekiVivek Kaul
The Federal Reserve of United States, the American central bank, plans to go slow on money printing starting this month i.e. January 2014. Until the last month the Federal Reserve printed $85 billion every month. It pumped this money into the financial system by buying government bonds and mortgage backed securities.
The idea was to ensure that there is enough money going around in the financial system and, thus, help keep long term interest rates low. This would hopefully encourage people to borrow and spend and, thus, help the American economy to start growing again.
The risk was that all the money being printed would lead to inflation. While the money printing hasn’t led to consumer price inflation, it has led to a rapid rise in the stock market as well as real estate prices in the United States. This is primarily because people (which includes investors) could borrow at very low interest rates and invest that money in stocks as well as buy homes.
“Since the turnaround began on March 9th, 2009, the S&P-500 index has chalked up gains of +175%, – ranking it as the fourth longest bull market of all-time. In cash terms, the US-stock market has generated $13.5-trillion in paper wealth,”
writes Gary Dorsch, Editor, Global Money Trends, in his recent column.
The 20 City S&P/ Case- Shiller Home Price Index, the leading measure of U.S. home prices,
rose by 13.6% in October 2013, in comparison to a year earlier. This is the highest gain in prices since February 2006, when prices had risen by 13.9% in comparison to the year earlier. Real estate prices in the United States, as measured by the 20 City S&P/Case- Shiller Home Price Index had peaked in April 2006.
So the markets in the United States as well as other parts of the world have done very well over the last few years as the Federal Reserve of United States has printed truck loads of money. The interesting thing is that even with the Federal Reserve deciding to go slow on money printing, the markets haven’t fallen.
It is worth pointing out here that when the Federal Reserve Chairman Ben Bernanke had first talked about going slow on money printing (or tapering as he called it) in May-June 2013, financial markets (stock, bond and foreign exchange) had reacted very badly to the news.
But when the Federal Reserve has actually gone ahead with “tapering” and decided to print $75 billion per month (instead of the earlier $85 billion) the markets haven’t reacted violently at all. Why is that the case?
One reason is the fact that the Federal Reserve has managed to communicate to the investors that tapering isn’t really tightening. What that means is that even though the Federal Reserve will go slow on money printing and not print as many dollars as it was in the past, it will ensure that short term interest rates will continue to remain low.
As Jon Hilsenrath writes in the Wall Street Journal “Most notably, the Fed’s message is sinking in that a wind down of the program won’t mean it’s in a hurry to raise short-term interest rates.”
This means at some level the dollar carry trade can continue. Hence, big institutional investors can continue to borrow in dollars at low interest rates and invest that money in different financial markets all over the world.
It needs to be pointed out that whether the Federal Reserve decides to further cut down on money printing depends on the overall state of the American economy. One particular number that the Federal Reserve likes to look at is the number of jobs created every month. In December 2013, the US economy saw a net increase of 74,000 jobs.
As Andre Damon writes “The US economy generated a net increase of only 74,000 jobs in December, about one third the number predicted by economists and less than half the amount needed to keep pace with population growth. The increase in non-farm payrolls was the lowest since January 1, 2011, when the economy added 69,000 jobs. Friday’s number followed two months in which payrolls grew by 200,000 or more, leading to claims that the economy was shifting into high gear.” This implies that it will be difficult for the Federal Reserve to cut down from the $75 billion that it is currently printing in a month. Hence, it is unlikely that the Federal Reserve will stop money printing any time soon.
What has further energised the financial markets is the fact that the Bank of Japan, the Japanese central bank, is also printing money big time. As Dorsch writes “The Bank of Japan(BoJ) has taken a page out of the Fed’s quantitative easing playbook, – but multiplied by 3-times. The BoJ is buying ¥7.5-trillion of government bonds (JGB’s) per month, and intervening directly in the equity market, by purchasing ¥1 trillion of exchange-traded funds linked to the Nikkei-225 each year. The BoJ aims to inject $1.4-trillion into the Tokyo money markets by April ‘15, equal to a third of the size of Japan’s $5-trillion economy.”
The Federal Reserve until last month was printing $85 billion every month. This works out to a around $1.02 trillion every year. The amount of money being printed by the Bank of Japan is more than that. What this means is that interest rates in Japan will remain low. This will encourage the yen carry trade, where an investor can borrow in yen and invest the money in different financial markets around the world.
What will also help is the fact as the Japanese central bank keeps printing money, the yen will depreciate against the dollar and thus spruce up returns. In the last one year the yen has gone from around 89 to a dollar to almost 103-104 to the dollar currently. “With liquidity injections of ¥7-trillion per month, Tokyo has engineered the yen’s -18% devaluation against the US$, -23% against the Euro, -15% against the Korean won, and a -12% slide against the Chinese yuan,” writes Dorsch.
How does this help yen carry trade? Let us understand this through an example. Let’s say an investor borrows 100 million yen and converts them into dollars. Currently one dollar is worth around 104 yen.
Hence, 100 million yen can be converted into around $961,538 (100 million yen/104). This money is invested in financial markets around the world and let’s say at the end of one year has grown by around 8% and is now worth $1.04 million. One dollar by then let us assume is worth 110 yen.
When $1.04 million is converted into yen, the investor gets 114 million yen. This means a return of 14%. Hence, the depreciating yen adds to the overall return for anyone who borrows in dollars.
It also means that financial markets around the world will see foreign investors continuing to bring in more money. India should also benefit from the same over the next one year. Given this, the BSE Sensex should continue to go up till December 2014. CLSA expects the Sensex to touch 23,500 by December 2014. Deutsche Bank Markets Research expects the Sensex to do even better and touch 24,000 by the end of this year. It does not matter that the real economy will continue to be in doldrums.

The article originally appeared on on January 13, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)