Just because it makes a good story, doesn’t mean it’s helpful

Human nature, it seems, prefers simple explanations over complex ones. Studies have shown that we are wired to be attracted to explanations that make sense at the first reading, as opposed to more complex information, even though it might provide a better explanation. This is because humans generally find uncertainty and ambiguity as undesirable, and so any reduction in these feelings is rewarding. Or, looked at another way, it’s often not the best explanation that wins out, but the one that people understand the fastest.

Humans also like stories. Stories have helped make sense of the world around us for centuries and it is how humans have passed down critical information through generations, often playing an important role in the survival of the species.

A preference for straightforward stories is how narratives tend to build in markets, even though often there is a wider or more nuanced picture to appreciate. In this sense, when financial markets are exposed to some sort of shock, as they were at the beginning of August, investors tend to look for the most obvious, reasonable-sounding explanation. Then they try to back-fill events with that story, providing a degree of comfort.

In this sense, since the recent market volatility, the focus has been on the role of the yen carry trade, the yen itself and unhelpful BoJ communications, combined with weaker than anticipated US economy data. This is understandable, as this was the scene of a lot of the stress, and it makes a good story. However, this encourages investors to focus on that same dynamic, rather than the broader picture.

US and Japanese interest rate differentials have been driving the USD/Yen exchange rate

Source: Bloomberg from 13.09.2021 – 14.08.2024. Past performance is not a guide to future returns.

Stepping back from the noise, there has been an important change in the dynamic of the world economy. The synchronised shutting of economies in lockdown and the subsequent coordinated loosening of monetary and fiscal policy has more recently given way to economies dancing to their own drumbeats again. For example, the Bank of Japan raising rates and the US set to cut rates illustrates how economies, and related policy, are moving in different directions.

Of course, on many levels this should be celebrated. The Bank of Japan picking rates up off the floor, from insanely low levels, and the US feeling comfortable enough about the inflation picture to suggest that cuts are on the way this year. Furthermore, that economies and policymakers are moving in different directions is a healthy sign from an economic perspective, and also from the perspective of global funds that are looking to diversify their assets across different sources of risk globally.

On another level though, the ructions the BoJ prompted, despite only moving rates from near zero to 0.25%, will not be forgotten and say something not just about the famous carry trade but also about how fragile the Japanese economy still is, particularly the consumer.

No doubt, going forward the BoJ will be much more careful in communication, and investors already have laser sights on the Japanese yen and the carry trade. That’s not to say that many, like us, won’t be reviewing their Japanese investments and reducing their exposure on the basis of poorer risk/return dynamics.

However, while investors are looking that way, the wider picture is that economies and policy-making are becoming less synchronised and this will throw up new dynamics. For example, via changing interest rate differentials and their impact on currencies, as well as opportunities, particularly opportunities to diversify.

This is not to say that that’s the end of market instability in the short term but just that investors shouldn’t expect stress to show up just via the carry trade, as many lessons should already have been learnt there.