Buckle Up: A Wild Ride Part 2

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Unprecedented Movements in the Market: What’s Happening?

In early August 2024 stock markets around the world declined precipitously, ending what seemed to be a never-ending low volatility trading environment. From peak to trough, the S&P 500 index declined approximately 10% in a handful of trading days; the volatility index as measured by the VIX, spiked from about 12 to over 60; and a similar index for bonds, the MOVE index, increased more than 50%, from 80 to over 120.  Similarly, the Japanese stock market, as measured by the Nikkei 225 index faired much worse, declining by over 25%, leaving investors rattled by the sudden burst of volatility. Markets have stabilized since. It’s been a wild ride, and a few more hills and thrills may appear in the near term—but why? The answer to this question involves Japan’s currency, the Yen, and the policy decisions of Japan’s central bank.

The Yen's Sharp Appreciation

The Japanese Yen's rapid appreciation against the U.S. dollar is a major contributor to the extreme movements in the stock markets, particularly because Japan is the sixth-largest U.S. trade partner (ranked based on total goods and services trade), a large source of foreign direct investment in the United States, and the largest holder of U.S. Treasury securities.[i] A massive unwinding of Yen carry trade positions has significantly contributed to the recent market downturn. So, what exactly is the Yen carry trade, and why did it cause a market downturn? It all started after the Bank of Japan surprised the markets by raising interest rates more than anticipated at their most recent meeting.

Understanding the Carry Trade

For years, Japan's central bank, the Bank of Japan, has maintained and ultra-low interest rate policy, which traders have benefited from. In this environment, investors borrowed Yen at extremely low interest rates and used them as a form of leverage. They could then convert the Yen to US dollars and other currencies to capitalize on the rate differential between Japan and countries with higher yielding currencies.

As the Bank of Japan began raising rates, an unwinding of the carry trade resulted, especially as rate cuts are becoming a greater possibility in the U.S. and European Union. Consequently, the Japanese Yen strengthened, and the USD/JPY currency pair just hit its lowest level since December 2023.

Forced Liquidation of US Stocks

And why does this shift matter? As the Yen strengthens, many of these Yen carry trades are being "margin called," by brokers demanding that investors deposit additional funds into their margin account. The era of "free" Yen loans has suddenly become quite costly. Faced with mounting debts and currency losses, carry trade participants are liquidating their U.S. stock holdings to repay Yen loans. This forced selling is intensifying downward pressure on U.S. equities, which have subsequently rebounded – to an extent…

Market Volatility

This unwinding, combined with geopolitical tensions and economic uncertainty in the U.S., has created a perfect storm of market volatility. The combination of these factors accelerated the market's recent downward trend. This is a very different situation than previous market downturns, and fixing it is not as straightforward as it may appear.

We’ve experienced wild rides before, and discussed them here. We understand that these ups and downs don’t have to be disconcerting if investors are safely buckled in with an investment strategy that can weather extreme and sudden bouts of volatility. The most dangerous move is to exit the ride before it comes to a complete stop. We at Highland can talk you through the ups and downs so that you can arrive at your investment destinations safely.

Call Mike Paolucci at 440.808.1500 if you would like to hear more about the impacts of carry trades on the markets, and how you might respond to the wild ride they have initiated.

[i] Congressional Research Service April 2024 https://crsreports.congress.gov/product/pdf/IF/IF11120

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