The stock market shock from Monday is still in the minds of investors three days later. After all, a crash of twelve percent in a single day on one of the largest stock exchanges in the world – the Japanese one – is not something you see every year, not even every decade. On Tuesday, the leading Nikkei index rose by ten percent, and on Wednesday by another one percent. So it is actually back near its starting point. But psychologically, the one-day crash in Japan, which spread like waves across Europe to the USA, has caused deep uncertainty.
The experts are still trying to find the cause: How can it be that, from the outside, such a panic-like reaction comes out of nowhere? There are now a number of theories circulating: the previous exaggerated stock boom, especially among technology companies, the looming recession in the USA, the looming escalation of the Middle East war. However, there is one reason that is increasingly emerging as the main cause of the upheavals.
Borrowing in yen, buying in dollars, that was lucrative for a long time
This reason lies in Japan and is called in technical jargon Currency Carry TradesThese are speculative transactions that attempt to exploit the interest rate differences between different currencies. Large institutional investors, who move billions, take out a loan in a currency with low interest rates and invest the money in a currency with higher interest rates. The interest rate difference is their profit. This is practiced on a large scale in the financial markets and usually yields high profits. Curry trades become problematic, however, when the relationship between the currencies changes massively within a short period of time. And that is exactly what has happened in the past few days.
Specifically, it is about the relationship between the yen and the US dollar. For a long time, the interest rate curves in Japan and the USA ran parallel, namely close to the zero line. But then the US Federal Reserve raised the key interest rate to 5.25 percent in 2022 within a few months, while in Japan it remained at 0.1 percent. A huge difference that professional investors such as pension funds or insurance companies have tried to exploit in recent months with ever larger sums.
An example: An investor takes out a yen loan of 100 million dollars from a Japanese bank at 0.25 percent and invests it in US government bonds with a ten-year term that currently yields four percent. This will bring him a return of 104 million dollars after one year. If he then pays back the loan, it will cost him 250,000 dollars in interest. The profit: 3.75 million dollars. However, this assumes that the relationship between the dollar and the yen has remained the same.
But recently the dollar lost up to 13 percent against the yen within four days. The reason for this was that interest rates in the two countries were moving in opposite directions: the Japanese central bank raised the key interest rate from 0.1 to 0.25 percent last week. The US Federal Reserve did not change the interest rate, but its head Jerome Powell mentioned the difficult labor market situation. This suggests that the key interest rate will soon be lowered in the USA.
The turbulence could continue for a while
The impact of the 13 percent exchange rate fluctuation on carry trades is enormous. A profit of $3.75 million in the example calculation becomes a loss of $9.25 million.
“I think that carry trades are blowing up in our faces,” says Roman Przibylla, investment expert at the securities firm Maverix Securities. Currency speculation was already going in the wrong direction for professional investors last week, and it culminated on Monday. “They had to reassess the risk and had high losses on their books,” says Przibylla. In order not to increase these losses even further, they had to close the carry trades. According to the major bank Société Générale, these were the largest such transactions ever seen in the world.
What makes matters worse is that the cheap yen loans were not only used to buy American government bonds. “Many investors took even more risks and stocked up on assets that had recently performed very well, such as US technology stocks, gold or Bitcoin,” says expert Przibylla. They also had to sell these assets on Monday to limit their losses. That’s why almost all asset classes around the world collapsed on Monday.
The question now is what will happen in the next few weeks. Expert Przibylla does not believe that all previously concluded carry trades have already been resolved. “Such processes usually take up to two weeks,” he says. It is therefore possible that there will be further heavy price losses. On the other hand, he believes that “the current distortions indicate that we are currently only dealing with a summer storm and not a tornado.” Because apart from the carry trades, the basic situation on the stock market has not changed much – and it is not fundamentally negative. Private investors should not sell in a panic in such situations; they could even use the lower prices to buy or buy high-quality stocks.
