Traders in Japan reached an important milestone on Friday: The benchmark Nikkei 225 recovered the entirety of the losses from August 5’s “Black Monday”. The carry trade situation appears to have stabilized, with institutional investors going back to selling the yen. And foreign investment has returned to Japanese Yen equities.
A “flash crash” in the wake of unexpected central bank action is more of the norm than the exception. The US had its own version of a market “tantrum” back in March of 2023 with the collapse of a handful of regional banks. In the American case, the market move wasn’t so dramatic, but some companies failed. In Japan, no companies failed (yet), but the stock market move was bigger.
Smooth Sailing Ahead?
We’d discussed in the lead-up to the crash how the BOJ was in a very difficult position, and risked triggering some kind of financial crisis by raising rates. At the time of the July 31 surprise rate decision, Japan’s central bank was under increasing pressure to do “something” to stop the slide in the yen. That something would have to be more aggressive than the interventions that it was doing at the behest of the Ministry of Finance up until that point.
So, the BOJ hiked rates by 15bps, and now its Governor, Kazuo Ueda is being called to Parliament to explain why he crashed the market. Hindsight is fantastic, especially for politicians. Of course, BOJ officials didn’t have a crystal ball to know that their rate hike would be followed by a particularly bad US NFP, which would lead to markets pricing in several more rate hikes by the Fed. In fact, the market move in Japan had more to do with the shifting perception in the US economy than what the BOJ did.
Minding the Gap
The carry trade works by taking advantage of the difference in interest rates between Japan and other currencies, including the dollar. Borrowing cheap yen and loaning out more expensive dollars, in this case. But if the interest rate differential shrinks, then the demand for carry trade will evaporate.
This creates a particular problem, since the carry trade means selling yen (in other words, betting that the USD/JPY exchange rate will go up). If the yen gets stronger, then stop losses on the carry trades get triggered. This can cause a snowballing effect as the stop losses force buying yen, raising the price even more (and pushing the USDJPY down). In order for the carry trade to work, there needs to be a difference in rates and the yen cannot be expected to strengthen in the near term.
Setting a Floor and Rising to the Future
That was why it was critical for the BOJ to essentially promise to not raise rates in the near term. But, this becomes a problem as inflation continues to rise thanks to the weaker yen. Now that they have tried the “big guns” and got hit by the ricochet, the BOJ will be less likely to tighten in the future. And that might give carry traders renewed confidence to return to their trades, potentially boosting the Nikkei 225 as well.
That return to the status quo before the BOJ made its move is dependent on data generally keeping the market happy. So far, US figures have supported a soft landing and not a recession. The incident showed that the Nikkei 225 and the yen carry trade is vulnerable, which means investors might be more skittish than before. In other words, be very wary of any surprises in the yen going forward.
