Financial markets worldwide were met with HUGE volatility last week with trading being halted in the Japanese stocks in particular. The S&P 500 was rocked with the biggest down move in 2 years and the VIX measure of volatility launched to Covid panic levels. By the end of the week markets worldwide had completely calmed down and stock indexes had bounced back. So this brings the question - what was the catalyst of the panic and is everything ok now?
The ”carry trade” is the large driving force of what caused last weeks panic. For years the Bank of Japan has kept interest rates at essentially zero allowing multi-national financial companies to borrow Japanese yen for free. Purchasing assets around the globe – and especially in the American capital markets – is the obvious next step. Traders may buy US Treasuries earning 5% with borrowed money they are paying 0% on. Pretty neat – but there’s more. The value of the Japanese yen vs US $ has been going down for several years. So traders make a margin on the interest rate PLUS they make money as the value of the yen goes down vs the $. Seems like an easy money factory – the problem comes in if the yen rallies back against the dollar. That’s exactly what happened last week. There was a wicked rally in the yen and the “carry trade” got blown out as investors had to close out their positions. There were hundreds of billions of $ that got unwound and the markets responded violently. Here is a picture of how quickly the yen rallied against the US dollar…
Carry traders that had borrowed money in yen terms to buy US tech stocks got wiped out. Things looked so bad on Monday that some people were advocating for an emergency rate cut from the Federal Reserve. Wharton’s Jeremy Siegel embarrassed himself by advocating for an immediate .75% rate cut followed by a minimum of .75% rate cut at the Fed’s September meeting. However, by the end of last week markets had recovered and volatility calmed down. Siegel’s comments didn’t age well and he even had to walk them back at the end of the week. Now of course the question is whether or not the “correction” is over and stocks will continue higher.
Although it is apparent that the bulk of the “carry trade” has been unwound already, we have concerns about the underlying economy that certainly don’t seem to be reflected in stock prices. The labor market is NOT doing well right now – unemployment is on the rise - and the credit markets are showing some worrying numbers. Is the American consumer running out of steam? Has the Fed kept rates too high for too long? Is something broken and will the rate cut in September have any effect? Time will tell…
Don’t forget we have had an inverted yield curve for more than two years. Historically that has been one of the most accurate predictors of recessions – but this anticipated recession just does not seem to manifest. Of course, one of the reasons for that is WILDLY inappropriate government spending (7% of GDP budget deficit for this fiscal year.) That is obviously bad policy but it won’t negatively affect the stock market – rather it is helping support the markets. This pullback in the stock market does not appear to be triggering further meltdowns in our financial markets. As a matter of fact, the yen has started to retrace some of the rally vs the dollar – possibly as traders put the “carry trade” back on– but stay tuned and don’t sell your gold!
Regards and good investing!
Greyson Geiler