S&P 500 Caution: The Fed Put Could Finally Break Thanks To Japan

This article is about how the Fed’s primary expansionary monetary policy tools are at serious risk of breaking in the next few months. This could have startling ramifications for the U.S. equity markets and most U.S. securities. The issue comes from the major catch-22 that the Bank of Japan is in and the unraveling of a global macro carry trade.

It’s not a far-fetched to say that the Fed is in a very tricky spot, and the situation with the BoJ only adds fuel to the fire.

Weakening Yen, Strengthening Yen, Carry Trades

I’ve seen the yen mentioned sporadically in the news throughout 2024. I first mentioned it in my article S&P 500: Seriously Time To Start Hedging written last month. This is what I wrote:

Finally, I see the continued devaluation of the Japanese yen paired with the uptick in Japan’s inflation as posing a possible persistent macro headwind which no one seems to be talking about. It is currently the cheapest it has been in years to visit Japan as a tourist (assuming you are using the euro or the dollar) due to how much the yen has collapsed against the dollar.

With Japan experiencing some higher-than-normal inflation for the first time in decades, we might see the Bank of Japan be forced to intervene in ways that will affect the value of the dollar, which in turn could lead to massive volatility in the US equity markets. What this might look like is selling US debt to buy the yen, something many believe happened extremely recently. Another possibility could be raising Japanese interest rates to a high enough point that it shuts down the lucrative dollar-yen carry trade. This would be followed by large capital outflows from US assets.

The macro specifics for this last factor could be an article on its own. I’m simply laying out some of the budding risks I see which motivate the need to strongly think about hedging.

Given the price action of the yen in the last month, I think it’s time to actually get into the macro specifics. Also, I apologize in advance for the unconventional display of the currency pair JPY/USD. I prefer to use USD as the quote asset. I’ve seen most people use the reciprocal pair but I think talking in terms of USD makes things easier for a wider audience (not just the macro natives) because that’s how most people think about stocks, ETFs, gold, crypto, oil, euros, etc.

The 6-month chart looks quite special: the yen has rallied 10% in dollar terms in the last month and reclaimed the previous 5 months of nearly non-stop decline.

This is likely due to serious intervention by the BoJ. Days ago, it raised rates for the first time since 2007. Raising interest rates in a currency helps the currency appreciate. In this case, we have to step back to realize what is going on.

You see, the yen has been collapsing for years because the BoJ ran 0 and even negative interest rates.

The BoJ is a pretty creative central bank. It pioneered QE years before the Federal Reserve did it in 2008 and 2009. The BoJ also did negative rates and yield curve control for years, two things which have only been theorized in the West.

Zero interest rates meant that traders could borrow yen for zero and invest in other currencies for higher yields. When the U.S. treasury yields started moving higher after 2021, there was a lot of borrowing yen at 0% and buying U.S. bonds at 5%. This is basically systemic short pressure on the yen (and by extension Japanese assets) and long pressure on the dollar (and by extension U.S. assets). This carry trade has been incredibly lucrative. However, as shown in the chart above, it has crushed the yen and is now causing record inflation in Japan.

There are a few answers to this. None of them are good. This is why the BoJ is stuck between a rock and a hard place. They can only let the yen go into freefall or intervene and reign in inflation.

In the discipline of international economics, this is the Impossible Trinity at play. A country or sovereign economic zone must choose two of three things:

• Fixed or managed exchange rate

• Independent monetary policy

• Free movement of capital

Managing the yen exchange rate will force Japan to either intervene with monetary policy or restrict the movement of capital. The latter choice gets very, very dicey, so this is usually not done (China is probably the only major economy which actually has capital controls). This means they are forced to intervene. If they do not intervene, they are letting the market set the exchange rate, which could potentially put the yen into free fall and effectively destroy the currency and most likely the Japanese economy.

Intervention Impacts

The BoJ must raise rates and/or sell its U.S. debt holdings to procure dollars to purchase yen. Those are the only two ways to force a better bid on the yen. They have raised rates. They are almost definitely also buying yen at random times in an attempt to discourage further yen shorters (by basically forcing them to close their shorts by pushing the yen higher).

When the BoJ raises rates, it is effectively closing the interest rate differential which has made the aforementioned carry trade so profitable. This means unwinding the carry trade, which will reverse the economic impact of the carry trade.

Remember, the impact of the carry trade was systemic sell pressure on the yen and Japanese assets, and buy pressure on the dollar and U.S. assets. The reverse of that would be precisely what we have been seeing in the last month:

• SPY and QQQ down

• DXY down

• Yen up

We’ve also seen U.S. yields fall, however, which is in my opinion more of a flight to safety response to some of the other stuff that is also going on, namely in the Middle East. But falling U.S. yields also helps close the interest rate differential and forces the unraveling of the carry trade, too.

All of this is going into an unanticipated U.S. labor market weakness and flashing U.S. recession signs. The Fed probably should cut rates, but that puts even more strain on the carry trade. Also, with U.S. CPI at 3.3%, the Fed is still quite far from their 2% target. The Fed did not cut rates but did say that it could be on the table for next month.

The most problematic outcome I see is if the BoJ sells U.S. debt to support the yen. This would certainly jolt the market because the higher U.S. treasury yields will hurt U.S. equities while forcibly closing out much of the remaining carry trade positions via a major spike in the yen (a possible short squeeze scenario).

The BoJ holds about $1.1 trillion of the $35 trillion total U.S. government debt. That probably won’t be absorbed so easily. If the Fed backstops the sudden selling pressure by creating base money dollars to buy the U.S. treasuries that BoJ is selling, then these dollars will very quickly end up in the hands of people selling yen to the BoJ (who would be using the dollars to buy yen). Would these people invest in U.S. assets? If they don’t then that would be more net selling pressure on the dollar, which could be inflationary for the U.S.

I think it could be possible that Japan may explore a form of capital controls if this still does not work. That could be another point of deglobalization, which is also inflationary.

Breaking The Fed Put?

The Fed put is a term used to describe the Fed being able to bail out the market with a liquidity injection. The Fed has always been able to create base dollars to lend to the U.S. government or to prop up asset prices.

The Japan fiasco could interrupt this because for the first time there may be an active large seller of U.S. treasuries which would be absorbing much of the base money creation. So, rather than the money going to the U.S. government to help with fiscal stimulus, you’ll have dollars being sold to prop up the yen. This weakens the dollar, is inflationary, causes higher U.S. yields, and hurts U.S. assets.

The Fed may find itself in a challenging dilemma of raising rates to fight off a resurgence in inflation or cutting rates to stimulate the economy and boost asset prices. And I’m not sure how effective cutting rates would be if inflation destroys real returns and absolutely wrecks the American consumer while the job market is weakening. For this reason, I think the Fed put may be on its last legs, even if in the future it could return.

Final Thoughts

If any of this transpires, we could see sizable volatility in the U.S. markets. The VIX has already been pushed up over 23, from around 12, which means that SPX options have on average doubled their implied volatilities. The market is in a major risk off environment right now.

I think it would be good to sit some of this out. Those who trade volatility need to be careful. On the one hand, volatility is at year-long highs and that is generally a good time to sell volatility. On the other hand, a lot of things could quickly happen to make the VIX climb much higher. If you are selling SPX or SPY options, position sizing matters. Smaller sizes are your friend in case volatility goes even higher from here. The more volatility climbs, the more marginally aggressive you can be.

We didn’t discuss many of the other things. AI stocks are seeming to get some lower multiples. Warren Buffett has slashed his stake of Apple (AAPL) and is raising cash. The tensions in the Middle East are getting worse. There’s a lot to dislike right now.

The long term view is that the S&P 500 remains a bet on the U.S. economy which is still the strongest in the world. These are very sound fundamentals. Don’t worry too much. Don’t sell in a panic. If you want, check out my hedging article for some ideas.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.