Bitcoin, widely seen as the hedge against relentless currency printing by central banks, has crashed more than 70% in less than six months.
Well, given that much of the advertising airspace at the latest cricket event in India was taken up by the upcoming coin exchanges, you probably know that cryptocurrencies have crashed.
Second, last Friday the Bank of Japan (BoJ) kept interest rates negative and guided to keep borrowing costs “current or lower”. This is contrary to virtually every other central bank in the world (they are raising their rates) as the BoJ estimates that inflation in Japan is lower than in western countries.
Following the policy announcement, the Japanese Yen (JPY) surprisingly depreciated. In theory (based on purchasing power parity), the currency of a country with low inflation should appreciate. Not only that, during past periods of aversion to risky assets, the JPY has acted as a stabilizer, barely moving.
This gives rise to another set of problems. When the currency of a country with lower inflation (and lower interest rates) begins to depreciate, it invites a “carry trade”.
This is how it generally works. In March 2022, you could borrow, say, one billion yen at interest rates of 0.15% and convert it to USD at the then prevailing exchange rate of 114 (equivalent to USD 8.8 million). You would then invest it at the then-current US 10-year rate of 2.2%. Since then, the USD/JPY exchange rate has risen to 135. Today, the carry trade investor has generated an 18% return in currency while earning a 2% interest rate differential.
In theory (again based on PPP), the currency of the country with a lower inflation rate (Japan in this case) should have a lower interest rate (which it does) and should see its currency to appreciate (which did not happen this time). Otherwise, there is free money to be made on the carry trade, and as we all know – or are now finding out – there are no free meals.
Since the late 1990s, during the cycle of rising interest rates, the yen carry trade was flourishing. The JPY was stable, the BOJ didn’t care if a few hedge funds made a few billion dollars here and there, and everyone was happy.
However, during the global financial crisis of 2008, the Fed had to cut interest rates without preparing the market beforehand, which delegitimized the carry trade. The JPY rose from levels of 120 to 80, and investors learned the hard way that currencies were finally catching up with the interest rate differential.
The strategy is akin to “picking up nickels in front of steamrollers”. You can be very successful for a while – until your attention is divided for a second and you lose your hand. The size of the global yen carry trade has fallen over 60% since the early 2000s, but given how lucrative this trade has become again, it would be interesting to see if it makes a comeback.
While these two events are interesting to note, they mostly reinforce some points that are relevant to us as equity investors.
First, things that in theory aren’t supposed to happen can very easily materialize and persist for a reasonably long period of time. Yes, Bitcoin was meant to be an inflation hedge. Yes, the JPY was supposed to be a safe haven currency. In theory, there is no difference between theory and practice; In practice, there are.
Also, things that have never happened before are happening all the time now. If our frame of reference is entirely based on what happened in the past, we are bound to be wrong. If we make this problem worse by taking leverage, we will certainly be wrong. Things can very easily get worse before they get better.
Second, even though our minds think in linear terms, everything with consequences works in cycles. We go from point A to point B and a significant amount of time (say 30 years) passes, we tend to forget the kind of volatility and drawdowns that were involved. Even when we look back at the COVID-led market correction, most of us remember what a great buying opportunity it was. It was barely two years ago. Memories of the 2008 crisis are fading; internet bubble must be blurry now.
Many of us will barely have investment experience during periods of quantitative easing; monetary policy has been accommodative for some time now.
For us, this is manageable if we take into account that (a) in the multiple crises that have occurred over the past two decades, history has hardly been a reliable guide to how things have turned out eventually unfolded, and (b) cycles have always existed (in market capitalizations, in sectors and in stocks). They will no doubt be more accentuated now; our style of investing will have to change to adapt to the changing times.
If we become aware of these facts and are not materially swayed by path addiction (buying something worth 150 to 100, with no material harm if it goes to 80 first), then I have a feeling we would do very well. Markets can take a while to stabilize, but we are finding more and more companies that have risen in value over the past year as their market price has fallen. Our time is better spent being on the lookout for these.
(Jigar Mistry is Co-Founder and Director, Buoyant Capital)