Grasping For a Reason

The market’s sudden swoon and the VIX spike this past Monday have left many people looking for causes, reasons, excuses, and explanations.  The most convenient has been the unwinding of the yen carry trade (which we discuss more below); however, there are a lot of highly leveraged quantitative investment strategies designed to trade around interest rate differentials, price correlations, relationships, and other data signals.  These “machines” move immense sums of money, and when they start to move, it is a good idea to pay attention… and to avoid getting in their way.

Currency Disorder Spooks Global Markets

As the recent correction began to unfold, market observers started looking for what was responsible.  Attention quickly focused on events in Japan.  Below, we’ll sketch the reasoning behind a conclusion that Japanese monetary policy and currency instability was most of the motive behind global markets’ subsequent gyrations.

We Warned about Yen Volatility Earlier This Year

Back in early May, we noted the Bank of Japan’s stealth intervention in currency markets, and observed the significance that the yen can have for global markets.  We wrote:

“We often say that ‘disorder’ in major global currency markets is very undesirable with regard to the performance of global risk assets such as stocks.  The Japanese yen had been steadily weakening versus the U.S. dollar for months.  The Bank of Japan [BoJ] indicated that the weaker yen was supporting the economy by boosting demand, but added that this weakness might require some form of intervention, as too rapid of a decline could lead to international scrutiny.  But the yen’s decline [has] started to get disorderly, which [has] forced some expensive central bank intervention.” 

The weak yen, while beneficial for exporters, raised concerns for Japanese policymakers due to increased costs for fuel and food imports, impacting consumption.

That intervention continued; on July 16, the bank promised “all necessary actions” to support the yen, and data from the BoJ showed an estimated total of nearly ¥6 trillion spent over two days.  The yen’s sharp rally after July 16 corresponded to the break of the U.S. stock market’s long and vigorous rally. 

Japanese Yen Value Last 100 Trading Day

S&P 500 Last 100 Trading Days

After July 16, analysts’ eyes turned to the upcoming BoJ meeting on July 31.  At that meeting, the BoJ raised its benchmark interest rate to 0.25% and outlined plans to halve its monthly bond purchases, marking an attempt to further normalize monetary policy despite unfavorable conditions.  This move contrasted with other central banks’ recent actions and communications, and narrowed the interest-rate gap.  BoJ governor Kazuo Ueda also indicated potential future rate increases if economic conditions aligned with forecasts.  Analysts were skeptical -- rightly, as it turned out -- noting that the BoJ’s actions might exacerbate economic and monetary instability.

How Japan’s Currency Wobbles Can Make Other Global Markets Swoon