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Extrapolating crypto market crash to equities

Over the past week, two important events transpired. One, the global cryptocurrency market cap fell below USD 1 trillion (USD 3 trillion at its peak in October 2021), and below levels observed in January 2018. As of this writing, cryptos have not only halved from pre-Covid highs but are at a four-and-a-half-year low.

Bitcoin, widely believed to be the hedge against the incessant currency printing by the central banks, has collapsed by over 70 per cent in under six months.

Well, given that much of the advertising airspace during the last cricketing event in India was taken up by the upcoming coin exchanges, you probably know that cryptocurrencies have crashed.

Second, last Friday, the Bank of Japan (BoJ) kept the interest rates negative and guided to keep the borrowing costs at a “present or lower” level. This is contrary to virtually every other central bank in the world (they are raising rates) as BoJ believes the inflation in Japan is lower than that in the western countries.

Following the policy announcement, the Japanese Yen (JPY) surprisingly depreciated. In theory (going by the purchasing power parity), the currency of a country with lower inflation should appreciate. Not just that, during past periods of aversion to risky assets, the JPY has acted as a stabiliser, hardly moving.

This gives rise to a different set of problems. When the currency of a country with lower inflation (and lower interest rates) starts to depreciate, it invites a ‘carry trade’.

This is how it typically works. In March 2022, you could borrow, say, one billion Yen at interest rates of 0.15 per cent and convert it into USD at the then prevailing exchange rate of 114 (equivalent to USD 8.8 million). You would then invest it at the then-prevailing US 10 year rate of 2.2 per cent. Since then, the USD JPY exchange has increased to 135. Today, the ‘carry trade’ investor has generated an 18 per cent return in currency while earning a differential interest rate of 2 per cent.

In theory (again as per PPP), the currency of the country with a lower inflation rate (Japan in this case) should have a lower interest rate (which is the case) and should see appreciating currency (which hasn’t transpired this time). Else, there is free money to be made on the carry trade, and as we all know – or are now finding out – there are no free lunches.

Since the late 1990s, during the rising interest rates cycle, the Yen carry trade used to flourish. JPY was stable, the BOJ didn’t bother if a few hedge funds made a few billion dollars here and there, and everyone was happy.

However, during the global financial crisis in 2008, the Fed had to cut interest rates without preparing the market first, which in turn, delegitimised the carry trade. The JPY appreciated from levels of 120 to 80, and investors learnt the hard way that, eventually, currencies catch up to interest rate differential.

The strategy is akin to ‘picking up nickels in front of steamrollers’. You can be very successful for a while – until your attention is split for a second, and you lose your hand. The size of the global Yen carry trade has fallen by more than 60 per cent since the early 2000s but given how lucrative this trade has now become again, it would be interesting to see if it makes a comeback.

While both events are interesting to note, more importantly, they reinforce a few points that are relevant for us as equity investors.

One, things that in theory are not supposed to happen can very easily materialise and persist for a reasonably long time. Yes, Bitcoin was supposed to be an inflation hedge. Yes, JPY was supposed to be a safe-haven currency. In theory, there is no difference between theory and practice; in practice, there is.

Also, things that have never happened before are happening all the time now. If our frame of reference is entirely based on what has happened in the past, we are bound to be wrong. If we compound that problem by taking on leverage, we definitely will be wrong. Things can very easily worsen before they improve.

Second, even though our minds think in linear terms, everything that is of consequence is operating in cycles. We go from point A to point B and a significant amount of time (say 30 years) passes, we tend to forget the kind of volatility and drawdowns that were involved. Even when we look back at the market correction led by COVID, most of us remember how it was a great buying opportunity. That was just about two years ago. Memories of the 2008 crisis are getting fainter; the dot-com bubble must be fuzzy by now.

Many of us hardly will have an experience of investing during periods of quantitative tightening; monetary policy has been loose for quite a while now.

To us, that is manageable if we take cognizance of the fact that (a) in the multiple crises that have happened over the past two decades, history has hardly been a reliable guide to how things eventually transpired, and (b) cycles have always existed (in market caps, in sectors and in stocks). They will arguably get more accentuated now; our investment style will have to change to suit the changing times.

If we take cognizance of those facts and are not materially leveraged to path dependence (buying something that is of 150 in value at 100, without it hurting materially if it goes to 80 first), then my sense is that we would do just fine. Markets may take some time to settle down, but we are increasingly finding businesses whose value has risen over the last year while their quoted price in the markets has fallen. Our time is better invested in being on the lookout for those.

(Jigar Mistry is Co-Founder & Director, Buoyant Capital)

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