We hope that everyone is having a great summer!
It’s been a very chaotic news cycle as we head into November’s US election and tensions continue to rise in the Middle East and in Eastern Europe. For a majority of 2024, markets have been the exception. As of mid-July, most global indexes were quietly positive. This especially true in North America as inflation (in both the U.S and Canada) has come under control and Central Banks indicating interest rate cuts in the near-future (Canada having completed back -to back 0.25% cuts). The recession fears had mostly subsided and the “soft landing” scenario looked more and more likely.
Fast forward two weeks and this narrative has been flipped on its head. The Nasdaq has been pushed into correction territory (a drop of 10% or more), the S&P500 and DOW are down 7% from their high and the TSX (which was closed on Monday) is down almost 1.5% intra-day.
Globally, Japan’s main stock Index, the “Nikkei,” has been the hardest hit, down 18% from it’s high on July 12th. Like any systemic issue, it is important to find its root cause to fully understand what is happening around the world.
Since the collapse of Japan’s asset bubble in 1992, they have favoured a weak exchange rate in order to boost exports (goods made in Japan that they ship to other countries around the globe) and support their domestic economy. In order to maintain a weak exchange rate with other global currencies (like the USD), they have kept their interest rate near or at 0%. And as Central Bank’s around the world were hiking rates at a blistering pace to combat inflation, Japan remained steadfast, keeping their posted rate at 0.10%.
Interest Rate policy (specifically in the US) has remained “restrictive” for longer than most investors had hoped. To combat this, investors looked elsewhere to minimize their cost of acquiring capital and maximize their profits. Enter the “Japan Carry Trade.”
To simplify: a trader will borrow Yen (Japan’s currency) at very low cost (0.10%) and immediately convert it to US Dollars. Given that interest rates are much higher in the US (The fed funds rate is 5.25% - 5.50%) there is a currency arbitrage (borrow at 0.10% and invest at 5+%). Not only were Traders and Investors buying US Dollar Debt (paying much higher yields) they were also investing in US equities in order to further maximize their gains on this trade.
“Unwinding” – sell shares or otherwise close a trading position, especially in a situation where doing so requires multiple transactions.
As the value of the Yen continued to decline, the spending power of Japanese citizens eroded. After years of economic stagnation and deflation, Japan is facing their own inflation crisis. This has forced the Bank of Japan and its policy makers to raise interest rates twice in the last 5 months (from -.10% to 0.10% and 0.10% to 0.25%).
Although the policy decision was domestic in nature (and exclusive to the Bank of Japan), it has had a significant impact on global markets and their index’s. Remember, the Japan Carry Trade involves borrowing Yen, meaning that these investments were made on Margin (borrowing from an investment bank to buy an asset). The original investment is impacted in four distinct ways:
1) The cost to borrow the Yen increased by 150% (from 0.10% – 0.25%)
2) Treasury/Bond yields in the U.S are going down (U.S 10-yr is now at 3.71% from a high of 5.02%)
30 The Yen has rallied against the US Dollar. To close this trade, investors need to pay back the Yen they originally borrowed. It will now cost them more to buy-back the Yen.
4) This trade is done on Margin meaning there is collateral assigned to the loan. If the cost to borrow the Yen increases and the value of the investment decreases, the bank you have the loan with will require more collateral, forcing you to sell part or all of the investment to meet the margin call (the demand from a bank or brokerage to deposit additional funds).
This has caused a lot of forced selling in the market as investors are obligated to meet the margin requirements of the brokerages and investment banks.
Where do we go from here?
The initial shock from the unwinding of this trade hit growth stocks the hardest. The most vulnerable investors (investors who took the most risk in this trade) were called immediately and forced to liquidate their positions. We have had a modest reversal of that shock today in the U.S, as all 3 major indexes are in the positive. We expect an uptick in market volatility in the short-term, but with easing inflation and the likelihood of rate cuts in the U.S, we see a bullish trend over the long-term.
In the big picture, this event highlights the importance of having bonds and fixed income in your portfolio. Bank of Canada (and US treasury) Bond yields have been steadily falling, increasing the value of your bond and fixed income holdings. Not only does this reduce the volatility of your portfolio, it provides a consistent income stream and in falling rate environments, capital appreciation.
If you wish to speak to our team regarding your asset allocation or risk objectives, please feel free to reach out to Jason and Adam.