Minsky Moments and the Butterfly Effect
Three weeks ago, on July 16th, the S&P 500 closed at an all-time high within spitting distance of a truly priced-for-perfection 5,700. We had AI-to-infinity and Goldilocks economic conditions sending the good ship S&P confidently sailing toward the horizon of higher. Just three weeks ago we had an autopilot market melting-up each sultry summer day.
Oh, how the picture has changed. This is no longer the year for sleepy summer markets. Not even close. Since peak summer slumber in July, we’ve had a growth scare, the massive yen carry trade has begun to unwind, and the short volatility trade has blown up like a firecracker. After bottoming out in July at a comatose 11, the VIX volatility index touched 65 on Monday before plunging back toward 20 on Friday. The current extreme volatility has occurred only twice before—November of 2008 during the Great Financial Crisis and March of 2020 during the Covid panic.
Make no mistake, volatility matters in and of itself. When prices turn volatile, financial leverage must be unwound. By extension, risk-on markets turn risk-off—in a hurry.
While the tremors rocking markets late last week into Monday of this one have subsequently eased, HAI cautions readers to remain highly vigilant. The rumbling witnessed so far, despite late week recovery, may just be pre-shocks foreshadowing a much larger and longer earthquake to come.
Economist Hyman Minsky theorized that long periods of investment gains encourage a diminished perception of overall market risk. The perception of diminished risk promotes the leveraged risk of investing borrowed money instead of cash. In short, excessive borrowing fuels financial instability. A “Minsky moment” describes the moment that instability is realized. It describes the moment when a destabilizing event occurs—as simple as an increase in interest rates or an unexpected move in a currency—that forces market participants to sell assets to raise money to repay loans. That, in turn, sends markets into a vicious spiral amid a demand for cash.
We witnessed a Minsky moment this week with the sudden unwind of the yen carry trade. It may not be the last such moment we’ll see in 2024. In fact, as far as realizing financial instability, this week may have amounted to little more than “the end of the beginning.”
The yen carry trade (or borrowing at low rates in Japanese yen to fund purchases of higher-yielding assets elsewhere) is by definition a leveraged trade, and it has long been one of the most popular trades across global markets. Institutional investors have piled into the trade, speculating that the yen would remain stable-to-lower while Japanese interest rates would remain pinned at rock bottom levels. However, an unexpected 11% appreciation in the yen against the dollar over the past month and a surprise 25 basis point rate increase by the Bank of Japan have suddenly upended many of those trades and turned them into highly leveraged losers.
As Arindam Sandilya, co-head of global FX strategy at JPMorgan, put it in a Bloomberg interview, “The trade has been pummeled this past week as yen volatility jumped amid fears of a looming US recession and after the Bank of Japan’s rate hike.” The resulting unwind of the trade initially hit asset prices across the board, and the unwind likely isn’t over yet. According to Sandilya, “We are not done by any stretch.”
What’s critical to understand in light of this carnage is that Western policymakers appear far more trapped than markets realize. Foreigners hold (are effectively short) $13 trillion in US dollar-denominated debt, and those same foreigners are also net long $22 trillion in US dollar-denominated assets.
In other words, just as higher rates and a stronger yen caused an unwind of the yen carry trade, higher-for-longer US Treasury rates and a US dollar that gets too strong will likely drive an unwind of the even bigger “US dollar carry trade.” In such an unwind, US dollar-denominated assets could get clobbered as a large portion of the foreign-held $22 trillion of dollar denominated assets gets sold to raise US dollars to pay off foreign-held US denominated debt. We got a painful taste of that dynamic in the third quarter of 2022 when the S&P 500 fell to 3,491 before the US dollar began to fall and a pause in US rate hikes came into view.
As HAI has pointed out previously, with $35 trillion in US government debt and a $2 trillion deficit (unprecedented at a time of full employment), the fiscal problem could blossom into a doom-loop crisis if tax receipts get hit by a falling stock market and a recession. That fiscal gun to the head has been a big reason HAI expects Fed chair Powell to ease monetary policy sooner and more aggressively than markets expected several months ago.
Now, however, last week’s partial unwind of the yen carry trade introduces a counter risk to financial markets. If the US dollar gets too strong and US rates are too high, it will drive a Minsky moment in the US dollar carry trade, threatening the global economy and markets. On the other hand, if the yen gets too strong vs. the US dollar, and Japanese rates move higher—as we just witnessed—it too will “Minsky” a further unwind of the yen carry trade and threaten to spread risk-off, similarly threatening the global economy, markets, and a US government fiscal doom loop.
In short, the real message investors should take from the partial yen carry trade unwind is that policymakers are increasingly cornered. A US dollar that’s too strong quickly becomes a systemic risk, and so does a US dollar that’s too weak (because it strengthens the yen and triggers global deleveraging and risk-off).
Ultimately, Japan’s commitment to radically activist monetary policy has left it unable to support its bond market and its currency at the same time. It is, after all, just as Ludwig Von Mises observed decades ago when he wrote that, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
On Wednesday, Bank of Japan Deputy Governor Uchida said the BOJ “won’t raise rates when the market is unstable.” The verbal intervention amounted to a capitulation from the BOJ. At least so far, it has had the intended effect of weakening the yen vs. the US dollar and temporarily stabilizing the situation. That said, the BOJ capitulation is just the latest evidence that central banks are trapped. They must keep their policy settings ever-easier and financial conditions ever-looser to keep from popping modern history’s greatest bubble.
As if market participants didn’t already have enough to ponder this week, the recent chaos and resulting explosion of volatility exposes an additional Minsky concern—the little understood potential risk of a “basis trade” unwind. The so-called basis trade involves playing two very similar debt prices against each other—selling futures and buying bonds—and extracting gains from leveraging the small gap between the two using borrowed money. As a Bloomberg article from a year ago pointed out, “The Treasury basis trade is large enough for the Fed to be aware that if it does overtighten by withdrawing too much liquidity, it could cause an accident in the system.”
A Financial Times article from 11 months ago said that while exact numbers are unknown, it estimates that the basis trade in the US Treasury market may be close to $1 trillion in size, and said that “traders have in the past been able to lever up to 500 times.” Both the US Fed and the Bank for International Settlements (BIS) have flagged the basis trade as a potential source of financial instability because of the potential “collision of heavy leverage with sudden and unexpected market movements, and the speed with which that can cause potentially serious problems.”
Again, volatility necessarily leads to deleveraging, and deleveraging is risk-off. If a new market regime of volatility and risk-off has arrived, that massive basis trade may be another Minsky moment waiting to happen. Such a risk matters because, as the FT points out, “the US Treasury market underpins the global financial system. The yield on federal government debt represents the so-called risk-free rate that is the benchmark for every asset class.” “Regulators say this all adds up to a situation where just a few large firms getting out of their bets could potentially encourage or force others to do the same, quickly leading to a doom loop of distressed selling in the world’s most important asset market.” Such a development would, no doubt, spiral into all other asset classes.
As Matthew Scott, head of rates trading at AllianceBernstein, told the FT, “My biggest concern is that if we get a big unwind in this leveraged trade, it could really cause liquidity to dry up in the Treasury market… In such a situation, it would be highly unlikely for the US central bank to simply stand back and watch.”
But now, in addition to the risk of re-accelerating inflation, the US central bank must carefully consider how such a market intervention would threaten other massive and vulnerable levered trades such as yen carry. Consistent with the unsustainable nature of our global financial circumstances, central bankers are losing policy optionality—and fast. Like the butterfly effect, central bankers intervening to ease one problem now increasingly run the risk of unintentionally releasing the pin that pops the global financial bubble halfway around the world. Given the rapidly escalating risks of Minsky moments and butterfly effects, along with newly stoked volatility threatening deleveraging and risk-off, the safest of safe havens remains gold, in HAI’s view.
Weekly performance: The S&P 500 was nearly flat, down 0.04%. Gold was up modestly with a 0.15% gain, silver lost 2.83%. Platinum was off 3.90%, and palladium gained 1.58%. The HUI gold miners index was down 2.08%. The IFRA iShares US Infrastructure ETF was off 2.02%. Energy commodities were volatile and higher on the week. WTI crude oil was up 4.52%, while natural gas gained 8.95%. The CRB Commodity Index was up 2.16%. Copper was lower by 2.68%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 0.70%. The Vanguard Utilities ETF was down 1.04%. The dollar index was nearly flat, down 0.03% to close the week at 102.96. The yield on the 10-yr U.S. Treasury gained 15 bps to close at 3.95%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
