Konnichiwa

What a week it was in the markets. It seems what was once old is somehow new again. This week was a real game changer in financial markets, and there is a lot to unpack, so let’s take a look.

There was a lot of corporate earnings out in the US all week, and they went from bad to worse, to even worse. Almost everyone of substance that reported dragged stock markets lower. Starbucks shit the bed, McDonalds somehow got it worse, and Amazon missed their Q2 earnings, AND gave a very dour outlook for Q3. It seemed every company that reported earnings dragged the markets lower and lower and lower. Intel lost almost 25% of it’s entire stock value in one day this week after it reported Q2 earnings. Stock indexes started the week off in the negative, and finished the week even worse with the NASDAQ entering correction territory ( down 10% from its previous high ), the Dow and S and P 500 also ended the week down mid single digits. All in all this week erased around 2 TRILLION of equity from stock markets.

Then we saw the US jobs report on Friday morning. That was when the hammer really got dropped. If you ever wanted to see what happens when a number misses expectations, then the US jobs report was a great example. The labor report showed only 114,000 jobs created in July, and the unemployment rate crept up to 4.3%. I imagine the revisions to the July numbers will come in well below 100,000 net jobs for the month once the dust settles.

So, why does all of this really matter to a mortgage broker in Canada? This is where we have to take a bit of a journey, but I promise it will be worth it.

Contrary to what a lot of people think, Canadian data does not have a lot to do with the reactions to the bond markets in Canada. What Uncle Tiff at the BOC does or does not do is a very small slice of what drives bond yields. Yes, the announcements when they meet are amazing ( sarcasm ) but all in all, what drives the Canadian economy, Canadian bond yields, and Canadian mortgage rates has nothing to do with Canada. You could read every Canadian data point, watch every BOC presser, know the Canadian GDP, CPI, inflation, every single number down to the 10th decimal, and you still wouldn’t have 10% of what you need to really move markets.

To figure out what is going to drive a lot of economic action and reaction in Canada we need to first start our quest in Tokyo. Yep, that Tokyo. When Japan’s economy crapped out back in the 80’s it forced the Bank of Japan ( BOJ ) to drop interest rates. In fact, for many years the BOJ bond rates were negative. Yes, you paid the BOJ to save your money in government bonds. Since deflation was so rampant throughout Japan, the thought was that you would be better to take a small loss and guarantee that loss, rather than gamble on the open market. So, bond yields were negative in some cases, but in all cases they were extremely low for decades. This created an opportunity. This opportunity is called the carry trade. The carry trade can be a bit complex, but I am going to break it down as simple as I can to get to the point.

When bankers and investors look to arbitrage out differences, they quite often rely on the carry trade. The theory is really really simple. In July of 2023 I could borrow money in Japan for 10 years for about 60 bps. I could then take that money that I was paying 60 bps on, and turn around and invest it in US Treasury bonds, that as of July 20223 were paying about 4.06%. That means I net out a difference of about 346 bps in difference, or profit. When the 10 years was up, I sold my US Treasury bonds and paid off the loan to the Japanese bank. Easy, peasy, lemon squeezy, right? Well, yes and no. A few things we must consider: exchange rates, and interest rates. Exchange rates are the factor that could absolutely crush your trade. In July 2023 the Yen to USD was around 142. That means 142 yen got me one US dollar. So, if I had 1 million USD to invest, I would have converted that to 142,000,000 Yen at the time. So, my loan is based in Yen and I owe 142 million yen. Now, the YEN took a beating over the last 12 months, dropping to a low around 160 YEN to the US dollar as recently as July 5th of 2024. For our trade above, this helps our return. When we originally converted the US dollars over to YEN we got 142 million Yen. Now that same US 1 million dollars is worth around 160 million Yen, so just on currency we have made 18 million yen, or about $112,500 USD just on our currency exchange. So, we have made 346 bps in interest difference ( 1 million x 346 bps ) of $34,600.00 USD , plus since the YEN weakened against the USD we have also made a profit of about $112,500 on currency. Total it all up and we have made $147,100.00 or about 14.71% in one year with putting no money in ourselves. Remember we borrowed the original amount in its entirety.

Now, finance being finance, and risk being risk, what happens if we instead took the money we borrowed in Japan, but invested it in stocks instead of US Treasury Bills? Well, I won’t bore you with the math, but if you had borrowed the same YEN and invested in a company like NVIDIA , then your total profit on the stock is about $2,523,955, plus of course your currency gain of $112,500 for a total of $2,636,455. This happens a lot, and people get bolder and bolder and riskier and riskier with their trades. Seems like a no lose situation, right? WRONG

A couple of months ago, inflation started to rear its head even in Japan, so the BOJ started to raise interest rates to counter inflation, and bond yields started to go up. This presents 2 problems for our friends in the carry trade. First and foremost, the cost of borrowing in Japan is higher, and as such is can start to quickly erode the spread you earn from borrowing in Tokyo and investing in Washington. Secondly, as interest rates rise so does the buying power and the strength of the YEN. In the last 3 weeks alone, the YEN has gone from 156 down to 142. That means, had you borrowed on or around early July 2024, you have now LOST about $98,000 just on exchange. At the same time. the prospects for the UD to drop interest rates is growing, and so the rate you can get on your bonds is the US decreasing. Higher borrowing costs, lower investment gains, and an appreciating YEN have now turned this into a threesome of losses.

So, what happens? Well, everyone starts selling their bonds, their stocks, and every investment they have to quickly re pay the YEN loan. As people start to buy YEN to repay their YEN loan, the value of the YEN rises more, and this puts more investors off side and into capital losses, so they buy YEN to pay back the loan ,and round and round we go. A lot of losses sustained this week in stock markets, bond markets, currency markets, commodities, etc were the process of unwinding the carry trade. The problem is that the chaos it creates can make for a lot of volatility, and that volatility drives people to the safety of bonds. We saw bond prices up, and yields down this week – especially in the US and Canada. This should lead to some rate reductions on Canadian mortgages – assuming we hold these levels.

Please don’t think the Canadian government bond dropped simply because people want lower mortgage rates. Please don’t think it is the result of a government trying to lower borrowing costs, and please don’t think that it is because Uncle Tiff is working his magic. Yes, interest rates are slowly working down, but keep in mind it is because the economy is circling the drain – IT IS NOT A GOOD THING, no matter what the Liberals post on social media. And for those of you that want to send me a message for slamming the Liberals – please go right ahead. I am quite frankly beyond tired of their misleading social media content surrounding finances. They are actively promoting that dropping interest rates is a sign of economic strength, when we all know it is a sign of economic weakness. Misleading the public like that should be a fucking crime. And we wonder why people make such boneheaded financial moves??? Perhaps if we had a real economist as a finance minister we could get the correct message out, but alas, here we are.

Carry trades will come and go, and start and stop. Last week was the example of the unwind of a carry trade. If things settle down and the carry trade can work again, we may see the reverse happen whereby bond yields go up, stocks go up, and the YEN loses value against the USD. Either way, please don’t think that last week was the start of a slow and steady rate decline, and no matter what a Tik Tok dancing realtor tells you – we are not out of the woods yet, and the worst is probably still to come.