Talking Intervention

Tushar Arora: If you invest that money in the US dollar, you get about 5% out, one year out. So unless the dollar spot moves 5% lower, you make money on that trade, right? And to finish that thought, a dollar yen spot is 5% higher in one year, rather than making 5%, you actually make 10% of the trade.

Bipan Rai: Hello everyone and welcome to another edition of the FX Factor podcast. I’m your host, Bipan Rai. And with me today, I’ve actually got a very special guest. It’s his first time on the podcast. Tushar Arora, Head of our Institutional Cross-Asset Structuring desk. Welcome to the podcast, Tushar. 

Tushar Arora: Thank you very much for having me, Bipan. It’s a pleasure. 

Bipan Rai: Yeah, absolutely. And I guess, I mean, it’s topical today because we’ve got to talk about the Bank of Japan. And for those of you listening to this, we’re recording this on Monday, after which the Ministry of Finance in Japan finally decided to intervene to prop up the Japanese yen. And as a result, we’ve seen several instances of suspected intervention. Of course, there’s never really been any sort of admission that this has taken place, but we can sort of use the mosaic theory to put two and two together. Now, you know Tushar for somebody like you that looks at markets closely and comes up with innovative ideas and solutions potentially to capitalize on them. How are you framing what we’ve seen from the Ministry of Finance overnight and what that means for dollar yen going forward?

Tushar Arora: Yeah, that’s a great question. And I love the way you preface the conversation. So it appeared that overnight, dollar yen touched 160. So you needed about 160 yen to buy one US dollar. That is the yen selling off. And that’s when the Ministry of Japan actively intervened. Like you said, we can never really know these things. But we saw a big move lower in dollar yen, which means that the yen strengthened against the US dollar overnight. And it appears that the magnitude of the move, especially in a thinly liquid environment because it was a Japanese holiday, that suggests that the Bank of Japan was perhaps concerned both with the magnitude of the move in dollar yen, but also perhaps the volatility that is surrounded that move. I mean, those are my thoughts, but I’m sure you have a better understanding of what really went on. So maybe you want to talk about that and just set the stage. 

Bipan Rai: Yeah, I mean, you know, some of the questions that we’ve received over the past several months, given the sort of fears or concerns that, oh, this is finally going to be the level at which, the Ministry of Finance is going to draw a line in the sand. And, you know, that level at one point was one forty five. Then it became one fifty, then became one fifty five. And finally, it’s one sixty. I think that’s part of the way or, you know, we could frame these sort of things. A more appropriate way would be to say, okay, look, there’s a potential line of the sand, but is there any sort of evidence as to whether or not there’s enough dollar liquidity being built up on the part of Japanese monetary authorities? And last week, we tend to take, every week I should say, we tend to take a very close look at the Fed’s balance sheet because there’s two line items, I think, that are very, very important in order to say whether or not, foreign counterparts to the Federal Reserve are building up dollar liquidity, one of which is the reverse repo facility used by foreign counterparties. And the other one is just sort of deposits held at Federal Reserve banks by foreign central banks. Both those shot up last week, right? So again, you know, there was this sense that dollar liquidity is being built up potentially to be used for intervention. And certainly when it comes to Japan, we’ve seen prior patterns, really observed in the case of prior interventions. But let’s take a step back and assume that, okay, intervention worked today. We went from 160, the last I checked, I think there was another potential round of intervention taking us towards 155. Let’s go with what the market’s thinking right now that this is going to be ineffective and it’s really driven by what the Federal Reserve is going to do. Tushar, in that sort of environment, let’s say we’re at 155, 156, this is gonna take some time to play out. So there is still the risk head a little bit higher with respect to dollar yen. When it comes to potentially solutions or alpha generating sort of ideas that you think about, I mean, how would you discuss that with clients? 

Tushar Arora: There aren’t, as you know, more than anyone else. There aren’t any universal truths in markets, but empirically we can gauge that certain things tend to work. And I would say in developed market effects, perhaps the thing that works better than any other strategy is this idea of being long carry. So said differently, an investor who borrows in yen and invests in US dollars makes about 5% a year if the dollar spot is unchanged. So, you know, to contextualize that because borrowing rates in Japan are about zero. And if you invest that money in the US dollar, you get about 5% out, one year out. So unless the dollar spot moves 5% lower, you make money on that trade, right? And to finish that thought, spot is 5% higher in one year, rather than making 5%, you actually make 10% of the trade. So that is the carry that’s in the market, right? So if dollar yen is 5% higher in one year, an investor who’s chosen to do this trade via the deliver to market via a forward instrument rather than making 5% would actually make 10%, right? Because the forward is 5% below current spot. So as you can imagine, right, this becomes a self-fulfilling prophecy, so to speak, recognize that others will have the same optimization function which is to borrow in yen and invest in the US dollar. Now of course there are clearly risks to the trade. One such risk to your point exactly played out last night and if we start to see more active intervention from a bank of Japan or more generally the Ministry of Finance in Japan and other investors recognize that this is what’s going to play out and maybe dollar and moves materially lower right so that’s the risk to the trade but short of that and maybe this is a good segue to the next part of our conversation but short of that in modern history especially in the currency markets which are probably the most liquid of all macro markets intervention has only worked when it has been coordinated across the large central banks the g4 so to speak right and i think the last time that really played out and my understanding is incomplete but the last time that really played out was back in the 80s in the Plaza Court where the Federal Reserve, the Bank of England, the German National Bank at that time and Bank of Japan they all decided to step in because the US dollar had materially appreciated against other developed market currencies and they found a way to secularly move the US dollar lower. So the point being, you know Do you think that while what Bank of Japan did overnight, you know while that clearly moved dollar in your lower strength in the end. Do you think Bank of Japan can singularly affect the course of the yen or do they have other policy measures that they must look at to uh continue this weakening and volatility in yen or do you think we’re going down the path of perhaps the major central banks convening again to affect the behavior of yen and more generally the secular strengthening of the US dollar in the last little while? 

Bipan Rai: So I mean initially when you asked that question my response is to say no and the only reason why is because the foreign exchange market is so much more deeper and more liquid now relative to the end of the time of the Plaza Accord where it was a lot easier to get things done and also to get more and more coordination between the different actors. But given the size and breadth of the market and the fact that, let’s just use one aspect of the argument and let’s focus on reserves. Most of the reserves held now are not in the developed markets, they’re held in the emerging markets and in a lot of cases with countries that aren’t particularly geopolitically aligned with the US or Japan. that can sustainably drive the edge stronger based on intervention itself is much more difficult to do now. And it really does come back to the fundamentals. An integral reason why we have a weaker Japanese yen is because monetary policy has now diverged on a sustained basis relative to the other central banks. And it really comes back to that point. And you know, there’s a lot of chatter about whether or not inflation is on sustained footing in Japan, whether or not we’re seeing the beginning of a virtuous cycle that, you know, UAE has spoken about, of course, Corona before him spent years talking about. I mean, if this is the trend that’s here to stay and, you know, you’re not tightening policy fast enough, the market’s going to punish you via a weaker exchange rate. So then, you know, one of the other things that I think is important to highlight and something that I want to talk to you about, Tushar, is when we look at the US dollar, it’s very special, not in the sense that it is the, that everyone thinks about, but it occupies a space where you do get rewarded via the carry especially against the Japanese yen, but you’re also long-convexed in that environment as well. Can you speak a little bit about why that’s so important in this environment? 

Tushar Arora: Yeah, that is such an important question, but I think It’s also at the heart of investment finance in some way, right? For all of the reasons you mentioned, the US dollar is special, but much more tangibly, the US dollar has this property of positive carry and positive convexity. So what does that really mean? It’s this idea that because US rates are higher than those for any other dollar against any other developed market currency, you know, with the passage of time carries positively. So if nothing happens, the spot doesn’t change, you make money on the trade. But, as we saw empirically during COVID, for instance, when things get really hairy, when there is risk off in the markets, the US dollar again strengthens. And there are, again, mechanical reasons for that. A flight to quality is really a flight to liquidity and the US treasuries are the most liquid instrument in markets that they really are right so foreign investors will look to buy US dollars the US dollar again strengthens. It’s very counterintuitive, but it’s very powerful in some ways this idea of an underlying which makes money in status quo if nothing happens, but also makes money thatthe world where there is pain, for example, in equity sell-off. To just finish that thought, if you think of equities, on average, over the cycle, equities will go up, but by definition and risk-off, equities correct, and that’s a painful trade. So now imagine if you could find an instrument that goes up if nothing happens, but goes up even more if there is risk-off. And that’s the special property of the US dollar. 

Bipan Rai: Right, right. And I guess it helps to understand which currencies in a particular regime will exhibit the strongest beta, let’s say, to risk off. I mean, let’s take this environment. We chat about this quite often because really, if we’re gauging the relationship between currencies and risk off, that relationship isn’t quite stationary. But can you speak to a few currencies that you think in this environment do exhibit the strongest relationships with risk off? 

Tushar Arora: Your question is very meaningful and I want to make sure I do justice to it. For the longest time, for about the last 20 years pre-COVID, risk-off colloquially was equity risk-off, right? So what that means is equities started selling off and investors who were long carry, so for example, long, the Australian dollar, for example, against the Japanese yen, they were forced to unwind the carry, right? Because you have liquidity constraints, you need to pull money back. And that mechanically led to a narrowing basis that we call in the markets between the yen, which has typically had the lowest interest rates in Australia, which has typically had the highest interest rates in G10 right? So risk off was primarily defined as equity risk off, which led to a suppression in rates between developed markets, which mechanically led to an unwind of the carry trade, which led to typically a rally in the Japanese yen. But in this chapter, we are seeing something very anomalous relative to history, or at least something that we have not seen in the last 35 years or so, is actually a sell-off in bonds rather than a sell-off in equity. So risk-off in this environment is that. And in this environment, because bonds are selling off, it’s actually led to a weakening in yen rather than a strengthening in yen as we talked about. And I think it’s very, and this might actually be a really good time to talk about the Canadian dollar as well, because we are at this juncture where US rates are higher than Canadian rates. It would appear, again, I’m no expert, but you are, so it appears that there is some chance that the Fed might not cut for a little while, maybe even be forced to hike, but it appears that Canada may be on the precipice of a recession, which would lead to Bank of Canada cutting rates. And what that would do is that would mechanically increase between dollar CAD would also be a risk off for the Canadian dollar. So can you maybe conjecture what dollar CAD could do if this state of the world played out? 

Bipan Rai: Yeah, if we’re talking currencies that are highly correlated with the risk we have to talk not just about the Australian dollar but the Canadian dollar as well. And yeah, you’re right. There’s been of late divergence between the Fed and the Bank of Canada. For now we’re comfortable with sort of a 50-bip divergence with the way that both central banks are going to move in 2024. Over the course of the cycle, I think that’s probably the right level to look at. And I’ll say this, there is, at least at this point, a limit to how far the Bank of Canada can diverge from the Federal Reserve. Before, the weakness in the exchange rate makes the Bank of Canada’s job more complicated when it comes to addressing inflation by the import channel. But there are, let’s call them shocks or instances where the Bank of Canada might be forced to diverge for longer from the Federal Reserve. And I think all roads for that lead to some form of scenario where you have households in Canada deleveraging. Whereas you don’t quite have that same potential issue in the United States becauseimmediately after the financial crisis of 2008, we did have US households that spent a considerable time deleveraging their balance sheets. And guess what? Dollar CAD actually traded through par during that time as well. So those are the types of shocks that can lead to a divergence between the two central banks where we have the Bank of Canada, potentially easing by more than the Federal Reserve. And at this, we’re not making that call, but let’s entertain the notion that we do see a significant deleveraging in the Canadian household sector. the Canadian dollar’s gonna be hit in that environment. Can we get up towards 145 in that sort of scenario? Potentially. But 145, 146, I believe that was the high during the COVID shock. And should we extrapolate potential momentum beyond there? History will tell you not because there’s going to be some form of mean reversion that plays out and of course we spend a lot of time talking about mean reversion ourselves and you know maybe this might be a good way to ask you the question I mean say dollar CAD goes to 145 146 and gets risk off I mean how would you think about things from that scenario?

Tushar Arora: As you know, my day-to-day entails using options, right? And options, especially a long options position, is a way to think about the unknown unknowns, right? Like to your point exactly earlier, it is very reasonable to conjecture that if spot gets to 145, empirically you will see a reversion. But I think one of the most asymmetric trades in the market out there is buying which is this idea that you could make a very asymmetric payout by buying structures that come into existence so to speak that become live if dollar CAD moves to the mid 140s and the high 140s primarily because dollar CAD volatility is is the lowest across all of G10 and we have to be able to show that even though the volatility is the lowest, markets are not taking away from your ability to buy these topside wings by introducing a lot of skew towards dollar cad, what we call out of the money calls. So all of this to say, dollar cad wings to the topside about as cheap relative to history as they’ve ever been at a time when Bank of Canada and Fed policies materially, at a time when we could see a big risk off in equities, which would again, mechanically sell dollar CAD higher, at a time when just a broad risk off, a big CPI print in the US could also send dollar CAD higher. All of this to say, we don’t think that’s our baseline, but we use our ability to think in terms of distributions, and we compare what we call the market implied distributions which is derived purely from option pricing with the empirical distribution, which is centered around the base case that you described, but has some tails. And we really think that asymmetry can be found in buying tails to the top side because markets haven’t quite priced, that tail scenario that might play out for all the reasons that you talked about. 

Bipan Rai: Okay. Awesome. Great conversation. Let’s do it again sometime soon. 

Tushar Arora: Sounds great. Anytime. Thank you very much for having me. 

Bipan Rai: No, not a problem. And thank you all for joining us. Until next time. Cheers.

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