Japan’s Yen and Market Volatility

I was reading quite a few pieces on the beginning of August’s market volatility but one in particular, from my investment advisor, caught my eye.

It seems like the decline in stocks from over the first week of August have been eliminated, which is great news.

A key driver of the market turbulence was the unwinding of the Japanese yen carry trade. I find this incredibly interesting…

Imagine the global financial market as a giant game of Jenga. The yen carry trade has been one of the bottom pieces, quietly supporting many investment strategies. Here’s how it operates:

1. Investors borrow money in Japanese yen at very low rates (Japan has had incredibly low rates for quite a while).,
2. They then invest that money in higher-yielding assets around the world, often in US stocks and bonds.

It’s essentially like taking out a low-rate loan to invest in a higher rate asset. Investors are trying to make arbitrage here.

Recently, the Japanese yen has strengthened by 14% in just one month. This rapid appreciation is primarily due to the Bank of Japan finally announcing interest rate increases after years of low rates.

This sudden increase in the yen required investors to rush to sell their assets so they can pay back the low-interest rate loans in a much more expensive currency… As they sold assets, primarily in the US stock market, it’s as if someone suddenly yanked out that Jenga piece, and the whole tower started to wobble. Japan’s stock market (the Nikkei) plummeted 13%, marking the single largest one-day drop since the Black Monday crash of 1987. The unwinding of stocks (sale of stocks), combined with some concerning economic indicators created a perfect storm for market anxiety. 

The carry-trade is what caused the market volatility at the beginning of August. Interesting? I think so 🙂

PS – the Bank of Japan mostly reversed its decision to increase rates and the market normalized pretty quickly.