IT WAS ALL GOING SO WELL! The markets moved from a warm summer’s day straight into autumn!
Equity markets had been rising for much of the year (up circa 10% year-to-date depending on which market you are looking at). But as always happens in financial markets, we had a shock, arguably multiple shocks:
- A surprise interest rate rise by the Bank of Japan leading to a sudden unwinding of the ‘Yen Carry Trade’ – see below
- Weak US economic data suggesting a recession is possible
- A belief that US technology stocks prices had run ahead of reality
1. Let’s look at each: What is the ‘Yen Carry Trade?’ A ‘Carry Trade’ is when you borrow money in a currency of a country that has low interest rates (so you have low borrowing costs ) and invest that money in currencies/countries that have higher interest rates or indeed invest in other overseas assets such as equities, property and more.
It works well if the currency you borrow in e.g. Japanese Yen stays the same or weakens versus the currency/country where you invest e.g. US/US Dollar assets.
It does not work well if the currency you borrow e.g. Yen strengthens against the currency you invest in e.g. US Dollars.
The Carry Trade is often referred to as the ‘Yen Carry Trade’ as over the last few years, and, indeed, at various times in history, Japan has had very low interest rates, often close to zero. Over the past few years you have been able to borrow Japanese Yen at zero per cent, sell your Yen for Dollars and invest in Dollar bank deposits/bonds paying you 5%. Even investing in US equities which have significantly gained in price this year.
The Yen had weakened substantially against the US Dollar over the past few years as Japanese interest remained near zero and the US Federal Reserve raised interest rates from zero (post Covid) to 5.25% as inflation took hold. A dream scenario for the Yen Carry Trade.
BUT last week there was surprise interest rate rise by the Bank of Japan, with the prospect of further interest rate rises, just at a time when US interest rates look set to be cut. The Yen has strengthened about 12% since mid-July (the biggest driver of the strength of any currency in the short-run is the level of short term interest rates). This caused numerous investors (from housewives to hedge funds ) to unwind the trade fearing further currency losses and higher borrowing costs. But “you can’t unwind the biggest carry trade the world has ever seen without breaking a few heads”. Markets have fallen sharply – see Market Reaction below.
2. Markets, which have been rising for most of the year, fell amid fears the US Federal Reserve (Central Bank) had been too slow to respond to signs the US economy was weakening and might be forced to play catch-up with rapid rate cuts. Short maturity US interest rates are still at a 20-year high of 5.25%! Markets now expect 4 or so rate cuts in the final 3 meetings of the year. Note – this factor driving the markets lower is, perhaps, even more important than the Yen Carry Trade factor.
3. US technology stocks had risen rapidly this year, driven by the promise of AI. The US technology NASDAQ index was up circa 20% for the year. But AI is not delivering profits today and there was already a move a couple of weeks ago out of technology stocks, rotating into small and medium size companies that might particularly benefit from lower US interest rates which are on their way. So the NASDAQ index was already fragile!
Market Reaction
All global equity markets have sold off sharply over the last 10 days with the US Technology NASSDAQ index down about 10%. Other markets 5-10%. The most dramatic faller was the Japanese stock market which was down 12.2 in one day (August 5th)!
As is normal on any equity market sell-off, investors have fled to the safety of government bonds driving prices up / yields down. (Current US 10-year yield-to-maturity 3.80%, UK 10-year 4.00% …approximately 0.30/0.40% (30/40 Basis Points) yield fall over the last 10 days. Gold is another ‘safe haven’ asset and has rallied to closed to $2,500 per ounce.
What next?
Markets are showing signs of calming down with equity prices at lower levels. A lot will depend on US company earnings reports versus expectations. Is the US economy slowing down rapidly? If it is, equity prices will fall further. Inflation news will also be important. A slow and steady cut in US interest rates will also likely steady markets. Let’s see!
