As currency markets opened Sunday at 5 p.m. New York time, Turkey was sound asleep and the Japanese were just waking up on their Monday morning. Long a favorite of Japanese households, the Turkish lira is dominated in Asia by many retail Japanese investors and this is the second time they've been spooked in the last year. Lasting only a few minutes, the Turkish lira fell against the U.S. dollar from TL 5.81 to the dollar to nearly TL 6.40 to the dollar. This "flash crash" lasted only a couple of minutes and it quickly recovered. The lira now trades up against the dollar at 5.79 late Wednesday. What happened and how can we learn from this event?
Near zero borrowing rates make returns on the Japanese yen nearly non-existent. This forces the Japanese to hunt for yield elsewhere. So, they short the yen (sell their Japanese yen) in exchange for Turkish liras. The yen they short are either their assets or are borrowed at very low rates. The Turkish lira they have now purchased is invested in interest accruing accounts to the tune of over 20% annually. In other words, if the Turkish lira depreciates by even 19% in one year, the Japanese investors make more money than they could have while investing in yen.
So what happened? Following the G7 summit in France, news of a prolonged trade war with China caused panic among investors. The U.S. dollar index began rising meaning all non-dollar currencies began to lose value against the dollar. As investors began to worry about losing money should the Turkish lira depreciates, as all their emerging market peers had done, they began to sell their liras. A moderate drop in the value of the lira, 1 to 2% caused a greater panic among investors. Before you know it, the lira was down nearly 3% when the margin calls began to come in.
Brokers will allow investors to borrow funds many times more than the money they have in their accounts so that investors can potentially make more money and so their commissions are more substantial. To make sure traders are good for the money they've borrowed, brokers will impose limits, such as "a 50% loss in the total value of the position will trigger a margin call."
A margin call is when the broker sells your assets without your permission to prevent you from being unable to repay them. This is generally done in the morning of each day. If investors borrow ten times the amount they have in their account and were down 5% on the Turkish lira they invested in, their position is said to be down 50%. Cue the margin calls.
As brokers unwound the lira positions by selling lira and buying yen, the Turkish lira lost a lot of its value in seconds. With few buyers awake at the time, the losses became more pronounced and caused the flash crash we're talking about. Those who realized what was going on made a killing by buying up all the liras being sold at the time. They each would have profited 10% in less than 10 minutes. Those that sold into the weakness realized losses they didn't have to.
Now the dust has cleared and the lira has appreciated against the U.S. dollar and other currencies relative to the beginning of the flash crash. While I assume the Turkish central bank acted to stabilize the lira early Monday morning, they could have acted quicker.
In this world of widespread "fake news," the slightest panic can cause a run on a currency and that will snowball into the crash in the lira we experienced in the summer of 2018. The central bank needs to be vigilant and a buyer of the lira all the time at predetermined logical levels.
The second lesson is for retail investors. Don't leverage yourself so much and risk margin calls. Finally, for those that aren't leveraged, don't be rash, act rationally. A massive move on any currency without any major news is almost always an overreaction. If you can wait a few minutes, you might just make a tidy profit.