Okay, the correction in the NASDAQ and the near correction in the Standard & Poor’s 500 isn’t all about Japan.
U.S. stock valuations are stretched. Air is coming out of the AI bubble. The U.S. economy is slowing
But to me those factors don’t explain the stunning rapidity of this drop. Nor why the biggest damage to any global market is taking place in Tokyo.
To me this event has all the hallmarks of a move that has more to do with the unwinding of massive speculative trades than with anything we might label “fundamentals” or “macro economics.”
Edward Yardeni, president of Yardeni Research and one of the smartest long-time observers of the financial markets I follow, points his finger at Japan and the surprise interest rate increase from the Bank of Japan that has led to a rapid unwinding of the speculative dollar/yen carry trade.
On July 31 Bank of Japan surprised financial markets with an interest rate increase intended to defend the yen against any further drop against the dollar. Japan’s economic data has looked so weak recently that no one was looking for an interest rate increase at this point.(Maybe in the fall?) The Bank of Japan raised interest rates by less than a quarter point—0.15 percentage points. That leaves the key rate now sitting at a still very low 0.25%. But the central point is that the Bank of Japan is raising rates when everyone else is cutting rates.
The move was such a surprise that it has led to a huge surge in the yen with the currency up about 8% against the dollar in the past week.
That has hammered earnings prospects for Japanese exporters.
And led currency traders to rapidly unwind their carry trade bets. In a carry trade position traders borrow in Japan at 0% interest rates and then use that money to buy U.S.-dollar assets such as shares of the Magnificent Seven tech stocks. The trade is only profitable, however, as long as the yen doesn’t climb against the dollar. An appreciating yen would force traders to pay back their borrowings in a suddenly more expensive currency.
Nobody wants to risk that. So sell. And sell fast. Because everybody else is selling too.
“Now, with the central bank of Japan tightening while other central banks are easing, the yen suddenly had a big move to the upside and that strength really led to a lot of margin calls of these speculative positions,” Yardeni told Yahoo Finance. “That’s all coming unglued. And I think it’s a lot of margin calls, and I think it’s going to happen pretty quick, and the unwind should be over by the end of the week.”
I’m not sure I agree with Yardeni’s time table. There are an awful lot of panicked traders trying to get rid of their short yen positions. And the only way to close a short yen position is to buy yen (after selling something else.)
But I do think we can look for an end to this extreme market volatity relatively soon.
The biggest long-term effect (if we define long-term as 6 weeks or so) may be to push the Fed into a 50 basis point cut on September 18 instead of just 25 basis points.
