Regular readers of Alphaville should be well aware that currency markets are implying a different set of short-term interest rates in some countries than the local money markets.
In theory, the dollar/yen exchange rate you can lock in three months from now by doing a currency swap should just be the dollar/yen exchange rate today adjusted by the difference between 3-month interest rates in America and Japan.
In practice, however, this hasn’t been true since around 2014. The gap between the US-Japan interest rate differential implied by the currency markets and the actual interest rate differential is almost a full percentage point. For example, buying short-term Japanese government debt and swapping an equivalent amount of yen back into dollars can currently earn you about 80 basis points more than what you’d get paid if you simply bought short-term US Treasury debt. This shouldn’t happen, which means someone is leaving a lot of money on the table.
A recent speech by the Bank of Japan’s Hiroshi Nakaso provides two complementary explanations.
First, Japanese savers, particularly insurers and pension funds, have been rapidly accumulating foreign assets — about 65 trillion yen since 2014, or about $570 billion at current exchange rates — and most of these assets are denominated in dollars:
These institutions are prudently hedging most of their currency exposure, which means they are paying banks a lot of money to swap dollars into yen. The value of these swaps purchased by Japanese savers has grown by about $400 billion (50 per cent) since mid-2014:
But this alone isn’t sufficient to explain the yawning gap between the relative cost of borrowing dollars in the US and the cost of borrowing them in Japan. After all, Nakaso notes “this is not the first time that we have experienced monetary policy divergence between Japan and the United States”, nor is it the first time Japanese savers bought dollar-denominated debt in size.
Unlike those previous episodes, however, this time around there aren’t enough people willing to swap yen for dollars, with the result that the dollar-yen basis is as wide if not wider than it was during the worst of the financial crisis.
Nakaso speculates the problem can be attributed to regulations that prevent big banks from exploiting the opportunity as they would have in the past. Hard leverage limits discourage banks from doing trades with relatively low returns even if the perceived risk is also low. At the same time, reforms to money-market mutual funds have curtailed what was once an important source of dollar funding for European and Japanese lenders.
To be clear, the widening basis isn’t itself a reason to think either reform was unwise.
Leverage ratios aren’t perfect but they tend to predict bank fragility better than risk-weighted capital ratios. Besides, plenty of seemingly riskless trades before the crisis (such as those exploiting the basis between the prices of credit default swaps and actual credit spreads) nevertheless managed to lose lots of money when combined with excessive borrowing.
And the pre-crisis money-market funds were the channel by which American corporate savers funded European banks as they purchased toxic mortgage bonds and inflated the housing bubble. Those money-market funds were also a prime source of instability during the crisis once savers decided their value was more market than money. Preventing a repeat of that experience seems like a worthwhile form of financial regulation.
So does this mean the basis will continue to be wide as long as Japanese and American monetary policy point in opposite directions? Not necessarily. There are other actors that could, if they tweaked their mandates, exploit the arbitrage opportunity.
For example, the Reserve Bank of Australia already picks up extra yield by putting more than half of its foreign reserves into yen and then swapping most of them back into Aussie dollars and American dollars:
Their explanation:
As has been the case for some years, when the costs of hedging currency risk are taken into account, yields on short-dated Japanese investments have generally exceeded those available in the other currencies in the Reserve Bank’s portfolio. Reflecting this, the bulk of the foreign currency the Bank obtains from swaps against Australian dollars is Japanese yen. For the same reason, the Bank also swaps other currencies in its reserves portfolio against the yen to enhance returns. As a consequence, while the Bank’s exposure to changes in the value of the yen remains small (consistent with the yen’s 5 per cent allocation in the Bank’s benchmark), around 58 per cent of the Bank’s foreign exchange reserves were invested in yen-denominated assets at the end of June 2016.
Presumably there are plenty of other yield-starved investors out there who could replace their holdings of short-term dollar assets with yen equivalents and swap them back into dollars to boost their returns. The interesting question is when they’ll start doing it, and if so, how long the opportunity will remain.