The REAL reason global markets crashed on Monday…

On Monday 5 August 2024, nearly $3 trillion was wiped out from major global indices… Bitcoin and cryptos were down 15%, 20% even more. The volatility index (The VIX) spiked above 50 – the first time since April 2020 during the Pandemic.  Simply put – Monday was a bloodbath for traders and investors. And very few investments were spared.

So, what caused the global asset rout?

Sure, you can argue that fears of a US recession have heightened after the recent poor jobs data. You can also argue a war escalation in the Middle East between Iran and Israel is creating volatility.

However, there’s an even bigger event that triggered a global market meltdown…

Japan and the Yen carry trade – what’s it all about?

According to Investopedia, A carry trade is a trading strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate. The proceeds also could be deployed into assets such as stocks, commodities, bonds, or real estate that are denominated in the second currency.

So, how does Japan and the Yen fit into all this?

Well, for decades, Japan has dealt with disinflation and deflation follow the Japanese market bust post-1989. During which, Japan’s one year government bond interest rates have been super low, and in some cases negative.

On the other hand, interest rates around the world and especially in developed markets like the US, UK and EU have soared over the past two years or so.

So as a trader, why would you borrow in the US/UK etc where the cost of capital is high. Instead, you can just borrow in Japan where the cost of capital is ultra-low.

Now, if enough traders do this, it becomes a huge deal.

So much so, that some estimate Japanese Yen carry trade to be around $4 trillion. Others estimate it to be around $20 trillion.

It’s hard to get an exact number. However, either way you look at it…it’s a lot of money!

Now, those traders who borrow Yen love it when the currency is weaker.

Why?

Because the weaker the Yen gets in your own currency against a fixed-loan liability that you took on from Japan, the more it helps your returns, because you’re paying back the loan at some point with Yen, which is worth less against a fixed amount.

Since 2010, the Yen in dollar terms has been weakening.

Why does it matter and what’s the risk…

The risk is oil…

Japan imports around 97% (5th highest consumer) of oil, because they have no international oil or gas assets. So, Japan relies on tanker shipments of gas.

Post the Fukushima crisis, they don’t generate as much electricity from nuclear. So, they need to import.

Now, remember oil is denominated in dollars, which means Japan must convert their currency into dollars to pay for oil/gas imports.

So, what happens when the price of oil keeps on surging, while the Yen continues to weaken?

The price of oil in Yen terms rises.

If the Bank of Japan continue to let the Yen weaken…it makes oil priced in Yen more expensive. This in turn impacts Japanese companies that need energy to manufacture. It also hurts Japanese consumers.

So how does the BOJ try and save the Yen?

1) Raise interest rates – which they’ve recently done.
2) They can mechanically buy Yen and sell dollars, meaning they become the last resort buyer of their own currency in the forex market.

The Bank of Japan recently intervened (by raising interest rates) in the market to try and defend the Yen. The Bank of Japan will likely continue to intervene because they don’t have a choice.

These moves help strengthen the Yen against the dollar.

But what happens when the Yen strengthens?

Well, the cost of the loan for global traders that borrowed in Yen becomes more expensive. That means, wherever traders deployed the cheap borrowed yen, they must now sell the stocks, bonds, commodities that they bought, because of the worry that the currency conversion will hurt them.

All this selling leads to a panic, where more selling takes place and eventually, a global margin call hits. We saw on Monday how many global assets were sold off leading to huge price drops.

As I write this, some assets have rebounded after Monday’s rout. But there’s still a big risk that the Japanese Yen carry trade will continue to unwind.

In my view, the best way to protect yourself is holding cash, which you can then use to scoop up stock market bargains.
And of course, gold is also a decent hedge against this risk. The shiny metal remained relatively stable during the global rout.

Simply put – the Yen Carry Trade isn’t a new phenomenon. However, it is important for traders and investors to understand how it works and the impact it can have on asset prices.

PS. Global Macro Trader is taking advantage of this volatility so if you want to profit in both up and down markets in a matter of days then make sure you’re part of this community!