Market Turmoil: Unraveling the Impact of the Yen Carry Trade and Global Uncertainties

The day? Monday, August 5, 2024. While having your morning coffee, you noticed the US equity markets were set for a rough opening. The futures markets were betting on the US equity markets opening down 2%-3% from Friday’s closing levels. European markets were trading down 2.5%, while Japanese markets had already closed down 12.4%. Numbers sobering enough to cure your vacationitis or latest COVID-induced brain fog. What is going on?

You turn on the news, hoping to hear the catalyst for such volatility. The talking heads are partially right suggesting the markets are refocusing on uncertainties. The economic data has been softening, opening the door for renewed recession prognostications. U.S. elections are less than 100 days away with some interesting twist-and-turns to date, enter U.S. political uncertainty. Not to mention, 2024 is a “super-cycle” election year with more than 70 countries holding elections. If that wasn’t enough, let’s add a pending Iranian strike against Israel potentially prompting a wider mid-East war. All this weighs on the market’s psyche.

Of particular note was the vast difference between the Japanese markets and other global equity markets. Why was Japan’s NIKKEI stock index down 12.4%? Few astute talking heads mentioned the Yen Carry Trade. After reviewing some data, you realize the Yen Carry Trade was the culprit.

So, what is the Yen Carry Trade? In short, investment professionals such as hedge funds or other speculative traders borrow money in low-rate Japanese Yen, then invest the money in higher-yielding securities denominated in other currencies, such as US Treasuries or Euro-denominated bonds. In effect, investors can pocket the yield difference. The assumption is that the currency exchange rates remain stable. However, since early 2023, the Yen has appreciated about 15%, wiping out the yield arbitrage.

Here’s where it gets a bit hairy. Those professional investors typically use leverage to amplify returns. At some point, the leverage overcomes the yield arbitrage, requiring leverage to be reduced. This is referred to as a margin call. Margin calls force the unwinding of the Yen Carry Trade, driving the Yen’s exchange rates spiraling downward. Anything denominated in Yen gets taken for the ride, hence the 12.4% decline of the NIKKEI. This was the main catalyst for the market decline on Monday, August 5, 2024.

There is no doubt that dramatic declines are sobering. In the heat of the moment, it can be difficult to identify the cause and even more difficult to maintain a level head. It is important to note that dramatic up and down days tend to be clustered. This means that selling on dramatic down days can often lead to missed dramatic up days. The reason for this is people tend to react first and ask questions later, which often ends with unfavorable results. Keeping emotions in check is what made Warren Buffet such a successful investor. Please enjoy these last few weeks of summer. Warmest Regards.

S&P 500 index measures the performance of 500 stocks generally considered representative of the overall market. DJ Industrial Average measures the performance of 30 US blue chip companies. The Euro STOXX index has a fixed number of 600 components representing companies among 17 European countries. The Nikkei 225 measures the performance of 225 highly capitalized and liquid publicly owned companies in Japan from a wide array of industry sectors. The information provided here is for general informational purposes only and should not be considered an individualized recommendation.

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