Japan’s Financial Markets are Sinking

As fears about a potential US recession spread, global stock markets have been affected. However, Japan’s market has experienced the most severe drop. On August 5th the Topix index fell by 12%, marking its worst performance since 1987. In contrast, stock markets in the US, UK, and Europe experienced more modest declines of 2-3%. The Topix index is now nearly 25% below its peak, reached just a month ago.

Additionally, the yen has rebounded, rising 13% from less than a month ago, when it was at its weakest in 37 years. These sharp shifts have broader implications not just for Japanese investors and firms. Given the country’s financial weight, these movements could contribute to increased volatility in already unstable global markets.

Nikkei 225 hits new lows

Japan’s Nikkei 225 stock index plunged more than 12% as investor fears about a worsening U.S. economy led to a broad sell-off of shares.

The Nikkei fell 4,451.28 points to 31,458.42, dropping 5.8% on Friday and marking its worst two-day decline of 18.2% over the last two trading sessions.

Its biggest single-day loss was a drop of 3,836 points, or 14.9%, on “Black Monday” in October 1987. It experienced an 11.4% decline during the 2008 global financial crisis and a 10.6% fall following a massive earthquake and nuclear disaster in northeastern Japan in March 2011.

Monday’s decline was the second largest percentage loss in a single day and the largest ever point loss.

Share prices have declined in Tokyo since the Bank of Japan raised its benchmark interest rate on Wednesday. The Nikkei index is now approximately 3.8% below its level from a year ago.

The wave of selling has affected a wide range of companies.

Toyota Motor Corp.’s shares dropped 13.7% and Honda Motor Co. lost 17.8%. Computer chip maker Tokyo Electron dropped 18.5% and Mitsubishi UFJ Financial Group plunged 17.8%.

Global carry trade and rising rates

The Bank of Japan raised its interest rate from a range of 0% to 0.1% to 0.25% on Wednesday, marking the highest level in 15 years.

Although the increase may seem small, it is significant because the yen has been the focus of carry trade, where traders profit from differences in interest rates globally. With global foreign-exchange turnover reaching a record $7.5 trillion a day in April 2022,the impact of such trades can be huge.

Japan kept interest rates ultralow for decades following the asset bubble collapse in the 1990s, which led to persistent deflation. It continued holding rates low even after the pandemic, in contrast to major central banks that started raising rates.

As a result, the Japanese yen fell to a near four-decade low against the strong US dollar last month. This divergence in monetary policy helped the carry trade, a popular investment strategy this year.

According to ING analysts, the carry trade involved “borrowing cheaply in yen — on the expectation that the yen will continue to fall — and investing in some high-yielding currency or asset preferably backed by a strong macro argument.”

Analysts also point to carry trades as a factor in the recent decline in share prices. These involve investors borrowing money from countries with low interest rates and weak currencies, like Japan, to invest in assets with higher-yields. Investors have been selling stocks to repay those loans as their costs have increased due to a stronger yen and higher interest rates.

According to a report from BMI, a unit of Fitch Solutions “The surge in financial market volatility was the result of a perfect storm of macro and market shocks at a time when risk assets were already overbought and overstretched.” The Bank of Japan’s decision to raise its key interest rate on July 31 “led to a sharp unwind of the yen carry trade, which added downside pressure on risk assets which were already selling off.”

Prior to raising its benchmark rate to 0.25% from 0.1%, for years the Bank of Japan had maintained the overnight call rate on its loans to banks near or below zero.

The dollar gained against the yen and other currencies as the Federal Reserve increased its own benchmark rate to a two-decade high in its fight against inflation. This increase, combined with a weaker yen, has driven up costs in Japan, which depends heavily on imports for essentials like food, fuel and other necessities.

In its latest economic outlook, the central bank indicated it would “accordingly continue to raise the policy interest rate and adjust the degree of monetary accommodation,” though this approach is now being called into question. Similarly, the Federal Reserve’s decision to maintain interest rates steady at least until September is also being questioned.

“The BOJ is arguably in a greater bind, struggling to credibly backtrack on hawkish guidance that has flown out of control, triggering an unintended Nikkei tailspin,” Vishnu Varathan of Mizuho Bank said in an analysis.

Calls to “keep calm and carry on” won’t fly, he said. “But to avoid self-reinforcing panic is perhaps the more critical thing for markets to avert a deeper sell-down.”

Yen drops as BOJ ease rate hike concerns

The yen fell sharply on Wednesday after a Bank of Japan official downplayed the chances of a near-term rate hike, easing investors’ fears that a further jump in the Japanese currency could again rock global markets.

The yen slid approximately 2.5% to a low of 147.94 per dollar following the comments from BOJ Deputy Governor Shinichi Uchida. The dollar was last up 1.7% at 146.79 yen.

“As we are seeing sharp volatility in domestic and overseas financial markets, it’s necessary to maintain current levels of monetary easing for the time being,” Uchida said.

His comments, which contrasted with the more hawkish tone of BOJ Governor Kazuo Ueda last week, when the BOJ surprised markets with an unexpected interest rate increase, boosting Japanese stocks, leaving them effectively flat for the week.

The BOJ’s recent rate hike, along with earlier intervention from Tokyo, led investors to bail out of once-popular carry trades where yen is borrowed at low rates to invest in assets that offer higher returns.

The carry unwind, combined with weak U.S. jobs data and fears about an artificial intelligence bubble, has contributed to a global stock market downturn this week, including a 12% crash in Japanese equities on Monday.

The U.S. dollar index, which measures the currency against six major rivals, increased by 0.15% to 103.13, moving further from Monday’s seven-month low of 102.15.

Rong Ren Goh, a portfolio manager at Eastspring Investments, noted that “Uchida has saved the carry trade – for now”.

“Japan policy is one of the important moving parts of the overall risk structure in the market. The other important ones would be U.S. economic data, which in turn informs Fed policy trajectory.”

The yen’s decline was broad based, with the Mexican peso, New Zealand dollar and Australian dollar – all involved in carry trades – increasing against the currency.

The euro eased 0.1% to $1.0923, down from an eight-month high of $1.101 on Monday as the dollar weakened. The British pound increased 0.1% to $1.2704.

Traders increased their expectations on Federal Reserve rate cuts on Monday after an unexpected rise in the unemployment rate on Friday, at one point pricing in more than 125 basis points of reductions this year.

Those expectations have gradually come down, with traders on Wednesday expecting 100 bps of easing this year and a 62% chance of a 50 basis point cut in September, having priced it as a near certainty on Monday.

In other currencies, the Australian dollar rose 0.64% higher to $0.6561, a day after the central bank ruled out interest rate cuts this year, saying core inflation is expected to come down only slowly.

The Aussie recently hit eight-month lows on Monday in the wake of the global market turmoil but rebounded following BOJ comments.

Mark Matthews, head of research for Asia at Julius Baer, said there is no need for the BOJ to continue raising interest rates. “After the dust settles, the very wide interest rate differential between Japan and other countries will once again become the primary determination of the yen’s valuation versus other currencies.”

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