In early August, advisors may have been fielding more phone calls from their clients than usual. Global markets experienced intense volatility driven by a confluence of economic factors. The turbulence began with weak U.S. economic data, compounded by the Bank of Japan’s unexpected interest rate hike, which unsettled market expectations and amplified risks. This led to a significant unwinding of yen carry trades, contributing to a sharp decline in stock markets worldwide and raising concerns about ongoing market stability. Keep reading for additional insights from our analysts.
An early-August volatility storm rattles global markets
More than a week has passed since weak manufacturing and employment reports in the United States raised the specter of a possibly impending recession, but major financial outlets are still attempting to untangle the multifaceted explanations for why volatility spiked so drastically. While the weak U.S. data gave stock and bond markets a jolt on August 2, the Bank of Japan’s surprise decision to raise interest rates the day prior combined with the market’s accelerated bets on Federal Reserve rate cuts, upended market participants’ expectations for the rate differential between these economies and others. These sentiments congealed into a potent risk-off brew over the weekend that weighed even heavier on markets on Monday, August 5, when light liquidity seems to have exacerbated the bad vibes.
All of this proved to be particularly relevant in yen-financed carry trade (more on that below) via which investors had, prior to the selloff, borrowed hundreds of billions of dollars’ worth of cheap-to-finance yen to invest in higher-yielding debt denominated in the U.S. dollar, Mexican peso, Swiss franc, and others. In retrospect, it became clear that yen-based financing extended to other assets, such as Taiwanese equities, U.S. tech stocks, and real estate.1 As one of the last central banks to meaningfully hike benchmark interest rates, the Bank of Japan’s decision to raise rates and guidance forced traders to unwind their leveraged trades as the yen strengthened against the backdrop of some weak data prints from a key engine of global growth in the U.S. economy.
While U.S. and Japanese stocks have recovered some of their losses as the Bank of Japan moved to reassure markets and the Fed still appears likely to cut is policy rate in September, Treasury yields in the U.S. are down and volatility remains elevated in a sign that the market remains on edge even if much of the yen carry trade has unwound and more recent reports show the U.S. economy seemingly on firmer footing than when the early August storm hit the markets. If history is any guide, markets often face elevated volatility in late summer and prior to major elections, so it remains to be seen whether the storm has passed or if it was just the leading wave.
Unwinding of the Yen carry trade
Driven by its surging currency (Yen), the Japanese stock market crashed on August 5 with the Nikkei-225 Stock Average Index (Japan’s equivalent to the Dow Jones Industrial Average) plunging 12.5%, its biggest single-day drop since the Black Monday in 1987. It caused global stock markets to fall sharply as well, as the S&P 500 Index tumbled 3% for the day. As Japan’s stock market is still dominated by export-driven companies like car manufacturers, the surging Yen hurt their export businesses and earnings. The hit on global stock markets and some other global asset classes, however, was mostly due to the sudden unwinding of the Yen carry trade.
What is carry trade? Carry trade is a popular trading strategy among currency traders to borrow low-yielding currencies and invest them in high-yielding currencies, seeking to profit from their yield differences. The Yen carry trade—borrowing the Yen and investing it in the Dollar or other higher-yielding currencies-had been very profitable in recent years until recently, as Japan not only had one of the lowest interest rates among major economies, but the Yen depreciated significantly against most other major currencies. For example, between March 16, 2022 (Fed started rate hikes) and July 3, 2024 (the Dollar peaked against the Yen), the Dollar rose 36% against the Yen. During the period, the Fed Funds Rate rose from 0-0.25% to 5.25-5.50% while Japan’s policy interest rate stayed negative at -0.10% until March 19, so there was a roughly 300 bps per year rate difference between these two currencies. The Yen carry trade has become so popular in recent years that it has been employed not just by currency traders but by many equity and commodity traders and even bitcoin traders, as they also borrow the Yen to invest in other risk assets.
On July 31, Bank of Japan raised its policy interest rate again to 0.25% from 0-0.10% after just raising it on March 19 and indicated it may raise again to support the Yen. As the Yen had already rebounded earlier in the month, the action of Bank of Japan accelerated the rise of the Yen and triggered the rush to unwinding of the Yen carry trade, hitting all kinds of risk assets. As many traders use leverage, there were many forced sellings as well.
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