In August stock markets have recorded huge crashes followed by a fairly rapid recovery. The turbulence has been linked to an unwinding of the yen carry trade, but there are other factors in the underlying dynamics.
The pro-cyclical nature of many systems in the financial markets mean that adjustments, which in principle may be necessary and rational, can overshoot. The unwinding of trades associated with borrowing in Japanese yen to invest elsewhere, contributing to a huge one-day drop of 12% in Japan’s Topix index, was triggered by an interest rate rise of just 25 basis points by the Bank of Japan on July 31, from effectively zero. This occurred at a time when speculation grew that the Federal Reserve would cut interest rates. A reduction in the difference between the Japanese and US rates would send many carry trades into the red. In addition, the falls triggered sell signals in tracker funds.
For professionals, for example working for pension funds, putting the bulk of investment into passive, or tracker funds appears to be a safe option – it won’t get you fired. Systems are primed to issue sell orders at certain data points, and these cascade through the system. There is a case for making such funds more sophisticated, with circuit breakers to prevent an unrestricted slide when just a few indicators turn negative. Passive funds are cheap to administer, and the amount of money going into them continues to grow.
The US labour market data that unnerved investors was the news that 114,000 jobs had been added, compared with an expected 175,000 – a disappointment, perhaps, but hardly heralding a Great Depression on a par with the 1930s. The unemployment rate was registered at 4.3%, up from a low of 3.4% in April 2023.
For all that the financial world is awash with data, there seems to be no accurate figure indicating the scale that the yen carry trade reached by the end of July. Estimates ranged from $500bn, according to UBS, to a colossal $4tn, which was the estimate of JPMorgan Chase. Much of this trade has since been unwound, but the scale is difficult to quantify.
There is more than one type of investment that could fall under the heading of yen carry trade. There is the borrowing in yen by hedge funds and other short-term investors to invest in assets internationally, many in the US but others such as the Mexican peso. In addition, there is investment by Japanese institutions and households internationally. A third category is purchase of Japanese equities by international investors as a currency hedge.
Since the crash in early August, asset prices have largely recovered. On August 19, Deutsche Bank reported that investments had been made particularly in index options, megacap technology stocks, cyclical stocks and defensives.
Another factor is that stocks were looking over-priced, such that many investors were looking for a signal to sell. The Magnificent Seven US tech stocks had been rising all year amid hopes that artificial intelligence (AI) technology was heading for a boom. This resulted in high price-earnings ratio that would be justifiable only under the more optimistic scenarios for the AI revolution. Some earnings announcements from tech firms over the summer were disappointing – but as with the labour market statistics, hardly alarmingly so.
Throughout the wild fluctuations in asset prices during August, many observed that the fundamentals haven’t changed. But the complication is that some stock prices still appear overpriced.
Added to that is a US Presidential election in November with policy offerings from both candidates that depart from IMF orthodoxy. This is not new in the US, but there are concerns over Kamala Harris’ indication that she would implement President Joe Biden’s proposal for a capital gains tax of 40% for those earning over $1mn, and hinted at rental and price controls while Donald Trump openly boasts about increasing tariffs, which could hamper trade. The US public sector deficit looks set to continue rising irrespective of who moves into the White House.
There are still indicators of economic growth globally, and inflation has come down from the highs of 2022. It is possible, indeed probable, that the US economy will find its soft landing. But there is a precedent for stock markets to crash in the northern hemisphere autumn: the three big collapses of 1929, 1987 and 2008 occurred in September or October. It could be a nervy final quarter to 2024.
