Central Banks' Tokyo Connection

"You keep playin' where you shouldn't be a playin'
And you keep thinkin' that you´ll never get burnt." -- Nancy Sinatra

Most of us encounter the Heisenberg Uncertainty Principle somewhere in our lives. Its derivation from quantum mechanics comes down to one equation with two unknowns, meaning you cannot know both a particle's location and its velocity exactly. The central equation in the foreign-exchange market has three unknowns, which helps explain the greater destructive powers of currency traders relative to nuclear physicists.

Central bankers face their own uncertainty principle between the money supply and interest rates, which are nothing more than the price of money. One of the lessons of the 1970s for the Federal Reserve was that a policy of targeting the federal funds rate could allow the money supply to grow in an inflationary manner.

It then switched to targeting the money supply, and that led to massive swings in short-term interest rates in the early 1980s under Paul Volcker. Greenspan addressed the problem through simple expedience: He would do whatever he felt necessary to manage some combination of the money supply and interest rates, all while bamboozling the market into believing he had the situation under control.

Quantitative Easing and the Japanese Zero

The Bank of Japan engaged in both strategies over the past decade. It first lowered short-term interest rates to the extent that three-month yen London interbank offered rate, or Libor, was trading below 1.00% in 1995. The yen carry trade, a topic I discussed in April, was born as the rest of the world feasted on cheap yen to finance all manner of things, including the late 1990s global equity market bubble.

The scale and pace of Japan's rate cuts are difficult to comprehend. If we plot both them and U.S. 10-year-note yields on a logarithmic scale to depict them in percentage-change terms, the history of the U.S. 10-year note looks downright boring. Focus on how rapidly short-term yen rates have jumped during the last two months and the implications for the yen carry trade for investors borrowing short-term in Japan to lend long-term in the U.S.

The Yen Carry Trade

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Source: Bloomberg