(Kitco News) - With interest rates at 23-year highs for more than a year, the Federal Reserve finally broke something, according to Edward Dowd, Founding Partner of Phinance Technologies, who warned that now the fuse has been lit for a global debt crisis.
In this latest rate-hike cycle, the Fed broke the Bank of Japan, said Dowd, stating that a global sovereign debt bubble is about to burst.
"What just happened in Japan took a lot of us by alarm, and we now think that the clock has been set for the global unwind of the debt in conjunction with a weakening U.S. economy," Dowd told Michelle Makori, Lead Anchor and Editor-in-Chief at Kitco News. "This is a very dangerous time. I believe liquidity is a big problem in the global financial markets. And as that becomes more apparent, we'll see more financial turmoil … It's going to manifest over the next 24 months."
Even though Wall Street seems to have put the unwind of the yen carry trade behind it, for now, Dowd forecasted more serious turbulence ahead.
Carry trades involve borrowing at a low cost in one currency to achieve higher returns from investments in another currency. The Japanese yen has been a popular choice for carry trades due to Japan's long-standing policy of maintaining extremely low interest rates. Investors borrow yen at these low rates and use it to buy currencies like U.S. dollars which offer higher yields. They then invest in bonds or other financial instruments in these higher-yielding currencies.
"Japan is one of the major central banks that has been coordinating easy money since the Great Financial Crisis. They've been keeping their interest rates essentially at zero for decades," Dowd said. "The Federal Reserve hiking interest rates very quickly caused the Bank of Japan's currency to weaken … The yen carry trade has been going on for decades. You could make the argument that the Japanese financial system is one giant yen carry trade."
Dowd explained that because of Japan's low interest policy, investors borrowed in yen and bought assets in other countries. "That trade blew up after decades of being used by many big players and large institutions," Dowd noted. "We have trillions of dollars in assets that are levered, and the trade is going the wrong way."
Following the volatility, the Bank of Japan Deputy Governor Shinichi Uchida sent a dovish signal, promising not to hike rates when the markets are unstable. "I believe that the bank needs to maintain monetary easing with the current policy interest rate for the time being, with developments in financial and capital markets at home and abroad being extremely volatile," Uchida said in a speech on August 7.
However, Dowd cautioned that financial turmoil might be unavoidable either way. "If Japan does not raise rates, it'll have another currency crisis on their hands. It is caught between a rock and a hard place. The bell just got rung. And it's the beginning of financial turmoil and heightened volatility," said Dowd. For his full thesis, watch the video above.
The yen carry trade explainer
- Japan's central bank started to raise interest rates for the first time in more than a decade. It hiked its short-term rate to 0.25% from 0-0.1% at the July 31 meeting.
- This was a surprise move, with markets expecting no change in rates. It was also the largest since 2007 and it came just months after the Bank of Japan ended an eight-year period of negative interest rates.
- Yen carry trades, which involve borrowing at low rates in Japan to invest in higher-yielding assets elsewhere, have been popular among investors. The strategy thrived as long as Japanese interest rates remained low and volatility was minimal.
- A sudden appreciation in the yen against the dollar over the past month has turned many of these trades into losses. The rush to close out short yen positions has impacted both emerging and developed markets.
This is the 'black swan' event to watch
Dowd cautioned that the U.S. and the rest of the world will continue to see ripple effects from what the yen carry trade unwind for months and years to come. "That was dropping a boulder in a pond and we're rippling out. We don't know what the knock-on effects are," he said.
Dowd also pointed to a potential 'black swan' event in the coming months. "The timeframe between crises is getting shorter and we need to keep accelerating the debt growth even faster. So that's why it's getting very precarious," he said.
The big unknown, according to Dowd, is the geopolitics and potential escalation of existing hotspots or a new hotspot. "If I had to give a probability of that occurring before the election, I would peg it at 30%, he said.
Watch the video above for insights into what that 'black swan' even could be.
Next crisis to trigger massive banking sector consolidation, 8 banks to call all the shots
Dowd warned that the banking sector will be another significant problem for the U.S. economy at the end of the year and going into the new year.
Even though the Fed was able to delay the banking crisis with tools like the Bank Term Funding Program (BTFP), which buoyed U.S. banks, the root cause has not been resolved and major consolidation in the banking sector is still ahead.
"What the Fed's tools are not going to patch up is a credit problem," he added. "We're now in the credit problem of the cycle, and banks loans are going to start to go sour, and they're going to have to report those losses."
Dowd stated that the U.S. will end up with just 6-8 major banks. "As the economy continues to weaken and we enter into a recession, bank consolidation will resume. And my prediction still holds – they'll eventually be six to eight banks. That's when it would be easier to introduce a central bank digital currency (CBDC)."
Watch the video above for details on what triggers it and how it could help usher in a CBDC in the U.S.
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