While Monday was an exciting day for short traders, many investors will be wondering how things were able to go so wrong so fast. The day was led by a huge fall in the Nikkei 225 index, which dropped further than other stock market indices, down over 12% on the day (the S&P 500 closed Monday down 3%).
The Nikkei rallied 10% in trading on Tuesday but brokers are warning we will see a lot of volatility in Tokyo in coming days. Investors should also bear in mind that the game has changed in Japan, as the yen carry trade unwinds.
We are anticipating further drops in the Nikkei. This is because the Bank of Japan has announced it was ending eight years of negative interest rates plus other monetary stimulus measures which were designed to keep the economy ticking over.
First JPY interest rate rise in 17 years!
The Bank of Japan has moved its base rate up to 0%. While that’s not a lot, its governor Kazuo Ueda has told the market he plans to return to a normal monetary policy target that starts to look like the behaviour of other central banks.
The Bank of Japan has been keeping the yen cheap and maintained negative interest rates when the other major central banks were hiking their interest rates. This created a huge carry trade for investors. It allowed them to borrow incredibly cheaply in the yen market and just park that cash in other higher yielding currencies, especially USD.
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The big issue here is that traders needed to be confident the Federal Reserve was not going to start cutting rates.
For the Japanese the cheap yen has meant companies have been able to sell their goods more cheaply in overseas markets, which has translated into positive momentum in the Nikkei 225. Japan also moved from a deflationary situation to hit a peak level of 4.3% inflation in January 2023. This has eventually forced the Bank of Japan into unwinding its loose monetary policy.
Note that the Bank of Japan is still out of step with most central banks, as it is now raising rates while others, like the European Central Bank, have started cutting their interest rates.
What does this mean for the carry trade?
A lot of investors have been making money on the carry trade since the pandemic, and they are now rushing for the exit. A perfect storm is occurring, with JPY rates going up while the Fed looks like it is edging closer to cutting US rates in September to avoid a recession. A lot of selling of US dollar assets is taking place as a result.
Investors will also be selling the Nikkei 225 as they can see the yen appreciate, in turn hitting the profits of large Japanese exporters. Many Japanese investors have been trading on margin, thanks to very low loans. That game is changing now, forcing many traders in Japan to start closing out positions.
While the Nikkei 225 may have rallied on Tuesday thanks to investors buying back in to pick up bargains, I’m anticipating we will see more negative than positive days for the index as we move through August.
Key takeaways on the yen carry trade
It looks like the Bank of Japan has finally burst the bubble for yen speculators. Whether it has the courage to continue down this path given both private and public debt levels in the country is an open question for governor Ueda. Let’s see how that plays out.
According to one fund manager I spoke to in Australia this week, the Nikkei volatility could create some fantastic buying opportunities for Japanese stocks, as some high quality names will get oversold amid all the panic. Just because the Nikkei 225 is being punished does not mean investors should be cutting their Japan exposure entirely.
