I have been formulating this analysis of Carry Trades and Assets since 2006, when I first researched Carry Trades to understand the Icelandic economy. The magnitude of the Carry Trade emphasises its impact on markets and its importance to Macro Economics, which heretofore has not been appreciated.

Many parts of this discussion are derived from my prior Crisis Notes (see the Archives) - I discuss the Carry Trade in almost every Crisis Note. The analytical framework that I have used since 1988 - that Hedging and Funding Costs determine Asset Valuation - has led me to research the supply of capital - primarily from Japan - and the resulting impact on the prices of assets that are described herein.

In this Note I am consolidating and augmenting my thoughts, and am attempting a comprehensive, and hopefully definitive, analysis of Carry Trades: how and why they are the primary determinant of Asset Prices, Money Supply and Asset Inflation, squeezing out the real economy in the process, and rendering Monetary Policy impotent.

The analysis and conclusions that follow are purely my opinion and conjectures, based on data I have collected and inferences I have made. I have not had access to Central Bankers, policy makers, or officers of banks, to really know how and what decisions they were making. I have also been scouring the internet for knowledge on the subjects discussed, but the information is sparse. It is quite possible that others have reached these conclusions before me, and might have also published on this topic, but I have not discovered any such sources.

The Shah Carry Indicator ("SCI")

I have created an indicator that quantifies the availability of Carry available, based on the various components of the Carry Trade that I identify below. This initial version of the SCI is focused on the US Economy, and in spite of not being a very refined model, has quite good explanatory power for a variety of assets and economic indicators. As discussed in the document, I also found more data that should be incorporated into the SCI, but is not at the present.

The graph above compares it to the S&P Index. As you can see above, the correlation is quite remarkable. The components chosen are based on my personal knowledge and from observation of markets and of flows of capital. The overall indicator is a linear combination of weighted carry sources. (Further research is likely to result in a Version 2 - I already have some ideas.)

The discussion that follows identifies the various components that determine Carry, and thus Asset Prices, in the US. This is a very general framework that can be applied to any economy that is the recipient of Carry capital flows from a Funding Country or countries. I have been making the argument for many years that the US is the world's largest recipient of Carry Funding, primarily from Japan, and that the Global Financial Crisis was primarily a Carry Deleveraging event.

In addition to Japan's almost permanent Carry Funding, the Fed periodically provides Carry Funding that is deployed both in the US and in Emerging Markets.

It is Aggregate Carry that determines Asset Prices, not Economic Stimulus from any single provider of Carry.

There are 3 major sections:

Carry Trades - describes the various sources of Carry at different points in time
Carry Trades and Assets - graphs showing the responsiveness of various assets to the Carry Trade
Macro Economics - the impact of the Carry Trade on Money Supply and the Transmission of Policy

Section 1: Carry Trades

“Carry Trade” is the term given to borrowing money in a low yielding currency (i.e. country), and investing the proceeds in the currency and assets of a higher yielding country, thereby earning a net spread, or carry.

Carry trades should never exist, as the economic concept of “Interest Rate Parity” should prevent any arbitrages from occurring. However, they do exist and are the most powerful force in Finance and Economics, as they thwart attempts by Central Banks to conduct monetary policy. The world as we know it today has been sculpted by Carry Trades, and almost all asset prices are a result of asset inflation (and deflation) from deployment (and withdrawal) of Carry Leverage.

I do not understand why Economists have not modifed their theories and macro economic policies to incorporate Carry Trades. My assumption is that, since carry trades should not exist due to no-arbitrage assumptions, economists think that they can be ignored, and thus continue to use their single-economy Keynesian models to manage policy. This is surprising, given the number of practicing economists that join or start Macro hedge funds that implement the carry trade.

In addition, I have even found discussion papers written for the BOJ, and also presented in the US, as recently as 2007, describing the Carry Trade, the export of capital, the funding of Hedge Funds in the US, and the ballooning of Credit in the US. Apparently they have been ignored.

In one of my incomplete 2009 Crisis Notes, I start to rewrite Macro Economics, and identified 'The Shah Theorem' (although it should be called a Hypothesis for now) that creates the Carry Trade:

When One Economy Enters a Liquidity Trap, All Monetary Policy Fails Globally

The primary result of Central Bank Keynesian stimulus policies, as executed by Carry Trades, is to export capital, preventing desired monetary expansion and desired inflation in the funding country, and instead creating excessive money supply and asset Inflation in capital-receipient countries, effectively exporting inflation. ( I proposed a solution to this in one of my old Crisis Notes, but since it is unlikely to happen, I'll save re-discussing it for later.)

In crime solving, they say, “Follow the Money”. This also applies to understanding financial markets. Without an understanding of the Carry Trade, investors cannot have an understanding of financial markets and risks, and functions such as Risk Management cannot be performed.

The Yen and Dollar Carry Trades

The original modern Carry Trade was the Yen Carry trade, deployed to great effect in 1994 by Julian Robertson of Tiger Management. It is quite likely that George Soros of Quantum, LTCM, other hedge funds, as well as Wall Street prop desks, were also using this strategy – many lost money at the same time – but there is very little information available publicly about their specific activities.

This trade is considered to be the most profitable trade in the history of hedge funds - borrowing money in Yen at very low interest rates, and investing it in other countries, initially and sizable in the US, but soon in many other market as well, such as Russian, Thailand, New Zealand, Australia, Iceland, etc.

The Yen Carry trade has not stopped funding the world’s productivity (or excesses) since then. In addition, we have also enjoyed periodic episodes of Dollar Carry Trade, and more recently to a minor extent, Euro Carry Trade, as both the Fed and ECB have effectively cut rates to zero. There are other countries with zero or negative interest rates, but their capital exports are not very scalable, so I won’t discuss them at this time.

All three major central banks have also embarked on Quantitative Easing to further increase money supply, in response to entering Liquidity Traps, providing more fuel for carry trades.

Due to the high leverage involved in Carry Trades, periodic periods of nervousness have led to the withdrawal of Carry Financing, leading to massive selloffs in Global markets: Leveraged Asset Growth comes hand in hand with Leveraged Downside.

Most periods of apparent de-correlation between Yen and various assets can be explained by augmentation by the periodic US Carry Trade, as well as Samurai Bond supply, which can dominate at the margin.

In addition, it must be kept in mind that the Yen Carry trade in the pre-Thai/Russia/Tiger/LTCM period was not well known. After Tiger made the news, the subsequent correlations of Yen Carry with financial assets increased, as did volumes in ancilliary measures, such as Repo and Margin.

The following chart shows the policy rates of the Bank of Japan (Unsecured Overnight Call Rate), The Federal Reserve Bank (Fed Funds Rate), and the European Central Bank (MRO – Main Refinancing Operations Rate).

Source: Bloomberg, MBS Mantra, LLC

1993-1998: The Yen Carry Trade

This was the period that made the Yen Carry Trade both famous and infamous.

The history of the Yen Carry Trade begins in the late 1980s, when, due to unconstrained money creation, Japanese asset prices appreciated greatly, and were part of a “bubble” economy. Subsequent deregulation of the banking system globally, and Samurai bond issuance rules in Japan (which I discuss in the Samurai bond Crisis Note) also played pivotal roles.

In 1989, The BOJ tightened monetary policy and raised its policy rate, continuing into 1990. In 1990, the bubble burst, and the Nikkei went from 38,915 to a low of 20,221 in 9 months. In 1991 and 1992, asset prices collapsed, resulting in large qualities of Non-Performing Loans (“NPLs”) at Japanese Banks, with numerous bank bankruptcies in 1995.

https://en.wikipedia.org/wiki/Japanese_asset_price_bubble

In a textbook Keynesian response to a financial crisis, the BOJ started cutting rates again, to allow banks to earn their way out of the crisis, and resulting in the creation of many ‘zombie banks’.

Japan’s policy rate crossed the US policy rate at 3% in October 1993, setting the stage for the Yen Carry Trade.

When, in March 1994, the US began to RAISE rates, following a recovery from the 1991 recession, the Yen Carry trade started in earnest. This resulted in a weakening of the Yen, an increase in borrowings from the BOJ by Japanese branches of Foreign banks, and a jump in Samurai bond issuance.

In the US, this resulted in a jump in margin borrowing, and a change in trajectory of the S&P Index in November 1994 (a “hockey stick”), starting a rally in US markets that continues even today, with interruptions in 2000 and 2007.

A number of important trigger events occured in this period, that are represented on the charts that follow as vertical lines with the following legends:

A: October 1993 - Yen Policy Rate Crosses US Policy Rate, signalling the availability of Carry Trades

B: July 1997 - Asian Crisis starts, with the failure of Thai markets

C: November 1997 - LTCM Peaks and begins failing

D: August 1998 - Russian Crisis Starts

E: September 1998 - 9/23 - LTCM is bailed out; 9/28 - Fed Funds are Cut

F: October 1998 - 10/7 to 10/8 - Tiger Management loses $2BB in one day; $5BB since 9/28

Borrowing from the BOJ

The Bank of Japan Uncollateralized Overnight Call Rate ("Call") is an overnight rate, similar to the US Fed Funds Rate, at which banks can borrow from the BOJ, or lend to the BOJ. "Assets" are money lent to the BOJ, "Liabilities" are money borrowed from the BOJ. I have to thank this recently found BOJ paper for identifying this data - I had been looking for it for years! This data does not break out US Banks, so it is not as direct as one would like. (I discovered this data on 2/2/2016, after I had created the SCI and written most of this document - it is not directly incorporated into SCI, although it is implied by the YCI. I will be recomputing SCI, and in the future to incorporate it).

Samurai Bonds

Prior to October 1993, Samurai issuance was sporadic. However, starting in October 1993, Samurai issuance increased dramatically, with $471mm being issued in that month. From January 1994 to January 2002, there was no month without Samurai issuance, with many months with greater than $1.5bb being issued. Supply in this first wave from 1994 to 1997 peaked in 1996, as word of this strategy spread to more participants, I presume. Issuance slowed as the Asian financial crisis was triggered in 1997. When the Fed cut rates in late 1998, after LTCM and the Russian Crisis (D), Samurai issuance slowed drastically. Large scale Samurai issuance resumed in 1999 after the Fed raised rates, while the BOJ cut rates once more to 0.1% , and also embarked on Quantitative Easing (“QE”), which I describe below.

Prior to the YCI going positive, US banks had

I recently finished a Note about the Samurai Bond Market, which gives extensive details about this market. I was alerted to the Samurai bond market when Lehman failed, and I read that 40+% of Lehman's debt was Samurai (I don't remember the source).

Between 1994 and 2000, $39bb of Samurai bonds were issued. Since the majority of the issuers were US financials, many of their bond liabilities could count as capital, allowing these issues to greatly increase bank balance sheets, and flowing through into US money supply, through margin and commercial lending.

In addition, a Hedge Fund’s prime broker could easily borrow in Yen from Japanese banks or Japanese branches of US Banks, as Japanese money supply had expanded while Japanese C&I lending had not, resulting in excess non-earning deposits. (Japanese banks in the 1990s would go as far as depositing their deposits at other Japanese banks to earn a return, in addition to continuing to make loans that had no hope of repayment.) I have not yet figured out how to fully identify and measure the size of this more direct Yen Carry funding.

The Role of Tiger Management (and other "Macro" Funds)

It had been known that Julian Robertson of Tiger was using the Yen Carry trade, and was the largest Macro Hedge Fund at the time, and that he was placing leveraged bets, but until Tiger blew up in the wake of the Russian and LTCM crises, the magnitude of the importance of the Yen Carry Trade, and Tiger, has never been quantified.

Quoting from the Paul Krugman link earlier in this post,

...Tiger Management, until recently the largest such fund in the world. In its heyday in the summer of 1998, Tiger had more than $20 billion under management, considerably more than George Soros' Quantum Fund, and was reputed to be even more aggressive than Quantum in making plays against troubled economies. Notably, Tiger was perhaps the biggest player in the yen "carry trade"--borrowing yen and investing the proceeds in dollars--and its short position in the yen put it in a position to benefit from troubles throughout Asia. But when the yen abruptly strengthened in the last few months of 1998, Tiger lost heavily--more than $2 billion on one day in October--and investors began pulling out. The losses continued in 1999--from January to the end of September Tiger lost 23 percent, compared with a gain of 5 percent for the average S&P 500 stock. By the end of September, between losses and withdrawals, Tiger was down to a mere $8 billion under management.

http://money.cnn.com/1998/11/02/companies/tiger/

From the link above we know the following:

- Tiger lost $5.5B between September and October 1998

- Tiger lost $2.1B in September 1998

- Tiger lost $3.4B in October 1998

- Tiger lost $2BB in one single day in October

- Tiger had 5.5:1 leverage

I use this information to understand the importance of Tiger to the US stock market. Here is what happened:

From the data, we know that the single day $2B loss probably occured on 10/7 to 10/8, when the Yen/$ moved from Y130.03 to Y121.3, a strengthening of Y8.73 (-6.71%), while the SPX went from 970.68 to 959.44 and lost 11.24 (-1.1%).

Looking at the 9/23/98 to 10/7/98 period, Yen/$ went from Y135.63 to Y130.03, strengthening by Y5.6 (-4.13%), apparently losing $2.1B for Tiger. In this period the SPX was also selling off, losing 95.41 (8.95%), from 1066.09 to 970.68.

We do not know specifically that Tiger was invested in the S&P - the SPX is a proxy for US assets.

Solving these simultaneous equations, we deduce that Tiger's position in Yen was approximately $27.98 billion, and position in S&P was approximately $10.55 billion! This does not make any assumptions about leverage or changes in leverage, we are just trying to estimate the sizes involved.

S&P volume was typically around 600mm in the periods prior to this volatility. From 9/23 to 9/30, SPX volume increased to around 700mm, and from 10/1 to 10/7 was between 700mm to 800mm. On 10/8/98, SPX volume spiked to 1.159B shares.

Between 10/7 and 10/8, 250,800 extra shares of the SPX traded over the prior days, with an 11.24 point decline for the day. Those shares had $2.818B realized loss on the SPX, on an invested amount of $243BB.

The jumps in volume suggest that Tiger and other similar funds were responsible for a significant percentage of the volume in the stock market in that period. This period also revealed other "Macro" funds that were playing in this trade, when their losses came to light.

http://money.cnn.com/1998/10/27/companies/soros/

Given that there were many other large "Macro" funds also investing in this period, I am standing by my opinion that the asset rally in the US from 1994 onwards was fueled by the Yen Carry Trade, and not by anything else Mr. Greenspan or the President might have attributed it to, such as a "New Economy".

And all economists that proclaimed that "the state of macro is good" or that "the central problem of depression-prevention has been solved" were dead wrong, as were their critics; in fact, Macro Economics had failed, and the problem was really simpler than one can imagine.

Yen Carry and the Stock Market

From the graph below, as well as the Samurai bond graph above, it is clear to see that, post 1994, as the Yen weakened, along with Samurai Bond issuance, the SPX rallied. The Yen strengthening after the Russian Crisis should have normally been a negative for Samurai issuance. Instead Samurai Bond Issuance picked up, since the Yen strength was offset by an increase in the Fed Funds rate, as well as the start of QE in Japan - this subtlety is captured by the YCI. As a result, the SPX resumed its rally in 1999.

1999 to the Present: The Yen and Dollar Carry Trades

Starting in 1999, BOJ's Call rate was close to zero, starting a decade of Zero Interest Rate Policy or "ZIRP". The BOJ also started deploying QE, adding more potential capital that could be exported.

In addition, "Mrs. Watanabe", the legendary Japanese housewife, also started trading Yen for other currencies, notably Aussie$ and US$, for yet more Carry Trades. This is discussed in previous Crisis Notes; I have not managed to identify data that captures the 'Watanabe flows' that are usually quoted by journalists to be over $1T; I suspect the Shah Carry Indicator's precision will improve even more once I do so.

Between Yen borrowing by banks, Samurai Bonds, Japanese QE, and Mrs. Watanabe, the Yen Carry Trade continued to fund the world, and especially the US. As Japanese money supply increased, along with Japanese M3, it searched far and wide for investments that would earn more than Japanese Assets. Thus began the phase that led to the Global Financial Crisis ("GFC") - after the supply of available investments was exhausted, assets were being created (notably Subprime and CDOs) to feed the voracious appetites of Carry Traders, further leveraged by Basel rules.

In addition, the US Dollar Carry trade started in earnest after 9/11/2001, as the Fed cut rates from 2001 to 2004. During this period, it possibly dominated the Yen Carry Trade, reducing the Yen's correlations to US assets and stocks. When the Fed raised rates again in 2004, the Yen once again became the dominant supplier of capital to the US.

The Yen Carry Trade continued unabated until US Asset prices started collapsing in 2007. You can easily spot the Deleveraging that occured in 2008!

In 2008, the Fed also started using QE, in addition to cutting rates again in 2007, once again triggering Dollar Carry, much of it to the Emerging Markets (discussed in this Crisis Note).

The Yen Carry Trade Indicator (YCI) will be a less effective measure for this period due to the additional sources of Carry, from both Japan and the US, and marginally the ECB. Since Japan has been in ZIRP for a long time, the YCI resembles the Fed Funds Rate. After 2009, when the US cut rates to Zero too, the YCI also went to zero.

There was some Samurai bond issuance after the YCI went to zero. This was primarily from financial institutions that had been bailed out. US markets and investors were still in shock, or wanted to export capital to EM for higher yields, whereas it appears that Japanese investors were still willing lend to US financials, who borrowed money where they could. (For more details, see the Samurai Bond Note).

As you can see below, Carry from Samurai bonds alone does not explain the price action of the US Stock market, although there is a link.

Quantitative Easing (QE) and Central Bank Balance Sheets

Quantitative Easing is considered an 'unconventional' monetary policy, and is used to increase money supply when conventional tools have become ineffective (i.e. rates are at zero).

Wikipedia has a good definition, so I will use it:

Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. A central bank implements quantitative easing by buying financial asets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the money supply.

When US QE was implemented, I discussed why QE cannot work, in the section called 'Bonds are not Assets' in the 2009 Crisis Note 'Excess Assets, Keynes, etc'. However, QE can increase the money supply by the amount of bonds purchased (similar to an addon wing on a car increasing downforce by the amount of it's weight). Without velocity of money, however, this is a pointless exercise, unless the goal is to enrichen banks.

All three major central banks have resorted to QE, at different points in time, after entering Liquidity Traps. The extent of QE that they have implemented can be measured by the size of their (ballooning) balance sheets. The following chart shows the magnitude of their balance sheets (in USD). Combined, they currently total $8.5T, of which approximately $7.5T is as a result of QE.

While the ECB's activities have not been very relevant to US asset pricing to date, Mr. Draghi's recent comments to 'do what it takes' might change the ECB's contribution to Carry Trades and US asset pricing. ECB data is being shown for that reason, and has been incorporated into the Shah Carry Indicator.

To summarize:

The Primary Carry Trades are the Yen Carry Trade and the Dollar Carry Trade. They export capital from Funding Countries to Carry Recipient countries, resulting in Asset Price Inflation, via:

Borrowing in Yen - Funding in Yen through banks, plus short Yen currency trading (Mrs. Watanable)
Lowering borrowing rates by Central Banks
Samurai bonds issuance (as well as EuroYen bonds), leveraging balance sheets of US banks.
Quantitative Easing, allowing funding country banks to export capital through 1 and 3 above.

These have all been incorporated in the Shah Carry Indicator.

Section 2: The Pricing of Assets

In this section we will compare the Shah Carry Indicator to a few Assets and economic indicators.

Please don't expect perfect correlations to all assets - there are other factors at work, such as hedge/leverage ratios that move with volatility.

Here is the SCI vs S&P chart again.

We have already seen the close relationship to the S&P 500 Index above. At the margin however, the Yen alone precisely explains micro movements in the S&P daily, tick by tick, day by day, suggesting to me that the S&P (and the US stock market) is controlled by Program and Algorithmic Trading, using the Yen as the funding and hedging source.

Yen and S&P intraday

Here is data from last week. Note that you need to make the trading hours the same on Bloomberg if you want to pull up the charts yourself. In previous notes, you'll find some intraday graphs from other periods.

Correlations using daily closing data get lower, possibly because of misalignment of closing prices, or changing hedge ratios in response to changes in the VIX, or maybe other factors. This is something I will study later to see I can model a hedge ratio more precisely.

SCI and the S&P 500 Price Earnings Ratio

Certainly correlated, but not as well as the Index itself - needs some beta/leverage adjustment maybe? There are studies that suggest that hedge ratios do change with movements in volatility and trend directions. There appears to be some concern in the markets that the current PE Ratios (and the resulting GAP to the SCI) are a result of financial engineering and buybacks of stock, and are limited in their stability, in which case they might come back more in line with the SCI.

Source: Bloomberg, MBS Mantra, LLC

As a bond market participant, I find this very interesting.

What is remarkable here is that, as the Yen Carry Trade became more popular, especially after 1998 or 1998, and prior to the 2008 Financial Crisis, bond prices, especially the 2 year UST, displayed movements related to the SCI, i.e. as the SCI went up, so did bond yields, and vice versa. (Bond prices move inversely with bond yields).

This was counter intuitive to me - I expected that the Carry Trade would have played out in bonds, lowering their yields - people usually think of the Carry trade as being an interest rate arbitrage trade - buy higher yielding assets in another country.

This, to me, suggests the asset allocation Rotation trade: out of bonds into stocks as the stock market rises and vice versa - the market at work allocating resources and capital to the highest returns, with bonds being sold to fund stocks.

Post Crisis, as the Fed became the dominant buyer of USTs for its QE Balance Sheet, bonds prices became more correlated to the SCI (their yields declined as SCI increased).

The Slope too, changed in tandem, suggesting rational duration management and more relative activity in 10s than 2s (flattening during bond rallies, steepening in selloffs).

SCI and Interest Rate Swaps (and LIBOR)

Source: Bloomberg, MBS Mantra, LLC

Another very interesting chart - the SCI is highly correlated with Swap Spreads in the Pre-GFC period! I attribute this to the data seen in the prior UST chart - selloffs in rates due to substitution into Stocks widen Swap Spreads, as credit bonds get sold at the same time. More Asset Allocation at work, and further proof that Carry funds Stocks more than Bonds!

SCI and Bond Funds and REITs

We will use the PIMCO Total Return Fund (PTTRX) and Annaly (NLY) stock as proxies.

Source: Bloomberg, MBS Mantra, LLC

NLY was mostly correlated with interest rates, and inversely with Carry, until 2005. PTTRX also has similar gross movements, but due to the tight scale and limited volatility (lower leverage than NLY), is not as visible. On Bloomberg you can execute {NLY Equity PTTRX Equity HSP <GO>} and change the dates for more scale.

SCI and Housing

Apologies to anyone in living in Miami. I chose Miami Single Family Home prices as an example of Carry driven housing assets.

Source: Bloomberg, MBS Mantra, LLC

SCI and Crude Oil

Not surprisingly, SCI explains most of Crude Oil's price history. One might argue that Carry (via the High Yield and CLO markets) gave the industry the capital to develop shale in the US, leading to the current price collapse. It is instructive to remember that Oil was at $20 before the Carry Trade started, and for most of the 1990s.

Oil and commodities in general above seemed to have started declining when QE3 was implemented, around September 2011. These markets seem to have taken Bernanke at his word, and commodities have sold off since then.

"The weak job market should concern every American. It imposes hardship on people.."

Section 3: The Failure of Macro Economics

In this section, I will explain what Central Bankers are attempting to accomplish with Monetary Policy, look at it's effectiveness in today's economic world structure, and look at what they actually do manage to accomplish. I will use the examples of the Japanese and US economies, and the policy decisions of each country, in this analysis.

A Summary of Monetary Policy

Central banks mostly attempt to manage money supply in order to control prices and target inflation. Some central banks have other mandates, such as employment targets and currency management, but the tools used are similar.

The ECB has put up a nice chart describing the Transmission of Monetary Policy.

https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html

In a prior Crisis Note, I have summarized the Bank of England's white paper titled 'The Transmission of Monetary Policy', which gives a good picture of what central banks are attempting to achieve. Here it is again:

- Central banks derive their power from the fact that they are monopoly providers of “high powered” money (base money).
- Central banks choose the price (rate) at which they lend high powered money to the private sector - the Policy Rate eg. Fed Funds Rate or Uncollateralized Overnight Call Rate.
- This official rate is transmitted to other market rates via the banking system to varying degrees, and impacts assets prices and expectations, as well as the exchange rate.
- These changes in turn effect spending, savings, and investment behavior, which impacts the demand for goods and services.
- Monetary policy works via its influence on aggregate demand in the economy. Monetary policy thus determines the general price level, and the value of money i.e. the purchasing power of money. (Inflation is thus a monetary phenomenon. )
- Changes in the policy rate lead to changes in behavior of both individuals and firms, which when added up over the whole economy generate changes in aggregate spending.
- Total domestic expenditure in the economy is equal to the sum of private consumption expenditure, government consumption expenditure and investment spending. This, plus the balance of trade (net exports) is equal to GDP.
- Monetary policy changes affect output and inflation, as well as inflation expectations. - Inflation expectations influence the level of real interest rates and so determine the impact of any specific nominal interest rate. They also influence price and money wage setting, and so feed into actual inflation in subsequent periods.
- Money supply plays a role in the transmission mechanism of policy, but is not a policy instrument nor a target, as the central bank has an inflation target, and uses monetary aggregates as indicators only.
- There is a positive relationship between monetary aggregates and the general level of prices. - “Monetary growth persistently in excess of that warranted by growth in the real economy will inevitably be the reflection of an interest rate policy that is inconsistent with stable inflation. So control of inflation always ultimately implies control of the monetary growth rate. However, the relationship between the monetary aggregates and nominal GDP ..appears to be insufficiently stable (partly owing to financial innovation) for the monetary aggregates to provide a robust indicator of likely future inflation developments in the near term.”
- Shocks to spending can have their origin in the banking system, that are not directly caused by changes in interest rates
– Examples include declines in bank lending caused by losses of capital on bad loans: a credit crunch.

As described in the previous sections above, the tools of Monetary Policy are the Policy Rate, Reserve Requirements, Margin Requirements, and more unconventionally, Quantitative Easing and penalty (negative) policy rates.

Money Supply

There are a number of measures of Money Supply, depending on the country, from 'narrow' to 'broad'.

- M1 is usually a narrow definition - coins and notes in circulation
- M2 is typically M1 plus short term bank deposits, savings and checking accounts, money market funds, etc.
- MZM - Money Zero Maturity - A measure of the liquid money within an economy. MZM represents all money in M2 less the time deposits, plus all money market funds
- M3 is M2 plus longer term deposits.
- Some countries have even broader definitions

Since Money Stock is relatively constant, each of these measures also has a 'Velocity' associated with it, which needs to be targeted to target inflation - "control of inflation always ultimately implies control of the monetary growth rate" - i.e. Velocity.

What is especially annoying is that the US Fed, in 2006, stopped measuring and publishing M3. I find this very suspicious, as I believe that the DIFFERENCE between M3 and M2 is critical for understanding the monetary forces at play in the economy. The public reason for not measuring M3 anymore was to save money, since M2 explained everything they needed, and M3 did not add any more explanatory power. To which I answer: Rubbish.

As you will see later, M3-M2 was on a rocket-like vertical trajectory in 2005-2006. My speculation is that the Fed could not or did not want to explain this, resulting in the cancellation of M3. Had they looked at it more closely, they would have spotted the Financial Crisis brewing. I need to see if they published the minutes of the meeting leading to the cancellation of M3, or whether it was done more surreptitiously.

Japan, on the other hand, also has problems with it's M2 and M3 data. The current official measurements were changed in 2003. The prior M3+CD series ended in 2008, and the prior data I have found from other sources is not 'good' - the OECD Japan M3 specifically looks doctored. We will have to tie together multiple series for Japan to make sense of it.

Quantity Theory of Money

Simplistic, but good enough.

MV = PQ

M = quantity of money

V = Velocity

P = Price Level

Q = Real GDP - quantity of real goods sold

Since M is usually stable, increasing Velocity will lead to inflation in P, and often, more resources allocated to increase the Quantity of real goods produced. Alternatively, you can increase M by printing money or increasing the Money Supply (QE is one way).

To generate Velocity of Money, the banking system is critical, as velocity is generated through the Fractional Reserve banking system, through Loans for Productive uses that then recycle back through the economy.

So, to generate Velocity, Lending is important, as is Productive goods production.

A criticism of the Quantity Theory of Money comes from Paul Samuelson (in reference to assumptions about velocity).

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.

As an alternative, I describe the IS-LM model in this Crisis Note, but you can refer to any Macro Economics textbook. The objectives are similar.

Targets of Monetary Policy

* Inflation Target
- There are 3 types of inflation that matter
- - Goods Price Inflation
- - Wage Inflation
- - Asset Inflation
* Full Employment
- - measuring employment and unemployment is a favorite sport of economists
- - the headline unemployment number does not represent reality
* GDP growth
- - we need to look into the components of GDP growth.
- - it is relatively easy for an administration to increase the size of government, but if it is not productive, it will not lead to Velocity of money.

Part 3A: Japan

Japan's Failure to Achieve Desired Results from Keynesian Macro Economic Policies

As desribed above, Japan entered a recession in 1984-1985, and has been struggling to get out of it every since. While official statistics show 6 different recessionary periods since then, in my opinion the entire peroid from 1989 to the present has been defined by the collapse in the measures of money - M2 and M3 - in 1989. Since then, the BOJ, and the government, have tried every play and trick in the economist's handbook, with limited to negative success.

Here is the official BOJ Japan Money Supply chart with Recession Periods marked.

Conclusion - Japan

The trends displayed in the preceding sections would lead one to conclude that Japan's economic future looks bleak, in spite of so much "Stimulus" being directed at it's economy. This raises 2 questions:

- Why does Japan insist on continuing with "Stimulus" and currency weakening?

- Where is all the "Stimulus" going?

The answer to the first question has been given to me by my friend, Manish Aurora of Rational Investing, who has been thinking about, has modeled, and has been trading the Japanese Stock Market. Paraphrasing him:

" The trouble is, Japan is 100 mm people on a few islands, and if they allowed their industrial base to hollow out, the country would become indefensible without projecting military strength throughout Asia, not to mention a banking system with significant resilience and reach as well."

In order words, Japan has no choice but to do whatever it can to survive or at least maintain the status quo, and if that means going into a bottomless pit of debt in order to remain a net exporter (so as to preserve its factories), it will do so.

The answer to the second question should be obvious from the first section - the Japanese Stimulus has been escaping Japan through the carry trade, providing unanticipated and uncontrolled Stimulus on other countries. However, I shall discuss it in the pages that follow.

Source: Bank of Japan, Fed, Bloomberg, MBS Mantra, LLC

While both these measures are instantaneous measures of the response to YCI incentives (i.e. Flow numbers), only the Net "Call" Liabilities of Foreign Banks are also a Stock number.

To assess the reduction in Japanese money supply, one needs to look at outstanding balances for the various components of Money Supply Export.

This graph shows the outstanding balances of Samurai bonds at different points in time. This data is estimated, as it does not account for any call execution for callable bonds, or any the elimination of debt due to bankruptcies (eg Lehman). Since much of this was debt that could count as capital for banks and financial institutions, the impact on US money supply was potentially magnified.

Another source of Japanese money supply export was Japan's investment in Foreign Bonds. This chart shows Japan's holdings of US Treasuries. The purchase of US Treasuries by the BOJ - loans to the US Treasury - directly injected money into the US Banks and thus the US economy, and the US money supply. This is directly analagous to the current QE being executed by the Fed, and has the same impact. (This explanation gives further justification to the inclusion of the BOJ's balance sheet holdings in the SCI.)

Section 4: An Alternate Reality - When Japan supplies your Money, are Fed Fund Rate Cuts counterproductive.

Stressing the components of the SCI. - delete FF, delete Fed BS. Test the data around 9/11/01 and Lehman

The SCI and YCI-2 do a good job of explaining changes in money supply in the US. But the 2002 to 2003, and 2007-2009 periods were both periods of declining asset prices and declining Yen Carry Trade flows.

If the Fed funds rate had not been changed, the YCI Indiciator would have remained high, potentially continuing the flow of interbank Yen transfers and Samurai bond issuances, which in turn would have boosted M3, and thus US Asset Prices.

Carry Trades in the Press

There has not been much discussion of the Carry Trade in the US press or TV. Various news sources do mention it, but it is so infrequent, that I am not sure how seriously this reporting has been taken. None of seem to quite understand the magnitude and importance it has.

Forbes, on September 4, 2014, finally had an article on Carry trades, to discuss the impact they were having on Emerging Markets.

http://www.forbes.com/sites/investor/2014/09/04/carry-trade-the-multi-trillion-dollar-hidden-market/#739c63a0761c

Barron's has discussed it many times, and a google search for "yen carry" finds articles from a few days ago, August 2015, 2006 and 2001. The Barron's articles prior to 2007 had some interesting insights and quotes from prominent hedge funds, but the warnings appear to have gone unheeded.

http://www.barrons.com/articles/rout-reveals-monetary-policy-dependence-1440431848

http://www.barrons.com/articles/SB116596521970248130

http://www.barrons.com/articles/SB50001424052748704878904578539353020226698

http://www.barrons.com/articles/SB116138320226999437

http://www.barrons.com/articles/SB984177852792122822

The Wall Street Journal (WSJ) had a primer in 2007 (that I missed at the time),

http://www.wsj.com/articles/SB117311273453827125

followed by this in 2012 - Yen Play is Blast from the Past

http://www.wsj.com/articles/SB10001424052702303812904577291651949362114

and some more articles since 2012.

http://www.wsj.com/articles/SB10001424127887324240804578414470218189706

http://blogs.wsj.com/moneybeat/2014/11/17/macro-horizons-japans-weak-gdp-puts-yen-carry-trade-in-focus/

The FT also does periodically refer to it, and David Pilling, the FT Asia Editor, is well aware of it.

In addition there have been numerous blog postings by a variety of people, so I am not the only one attempting to raise awareness of this issue, even though I discovered it on my own.

Much more discussion of Carry Trades occurred in the 1990s, especially after Tiger Management blew up in 1998 (discussed below). However, most of today’s current market participants, especially in the US, appear to be unaware of it.

Most economists that study the Yen and Japanese Financial Policies do so in the context of why Japan cannot create inflation, Liquidity Traps, Japan's Lost Decade(s), and Japan's fight against Deflation. Very few make the connection to the Carry Trade. For example:

http://www.nber.org/chapters/c0092.pdf

Paul Krugman is an US economist who us a Japan Expert, and he has discussed all the topics listed above, and the Carry Trade, but once again, does not appear to have connected the two.

http://web.mit.edu/krugman/www/jpage.html

http://www.slate.com/articles/business/the_dismal_science/1999/11/tigers_tale.html

Prior to 2012, the Yen, or Japan, were rarely mentioned in the Wall Street Journal or on American business TV, or acknowledged by economists, displaying American belief and even arrogance in the American economy being the dominant global economy and being isolated from other global forces, and having its own valuation metrics. As Paul Krugman points out, most economists in the 2000s, including Ben Bernanke, believed the Business Cycle and Macro Economics to be “solved”.

During the Great Financial Crisis, Australian newspapers and economists (especially Gerard Minack) were far more keenly aware of the underlying economic events than American papers and TV. There has been some progress on awareness of Yen (it now shows up on TV sidebars nowadays), with journalists still ignorantly identifying it as a ‘Safe Haven’ on days the markets are selling off, as opposed to THE cause for movements in US Stock markets.