The end of the yen carry game: Global markets face Black Monday

Author: He Xi, Ji Zhenyu Source: Tencent News "Qianwang"

The flapping of a butterfly's wings triggered a tsunami in the global financial market.

On July 31, the Bank of Japan announced that it would raise its policy interest rate from 0% to 0.1% to around 0.25%. This was the first interest rate hike since Japan ended its negative interest rate policy at the beginning of this year.

On the same day, the Federal Reserve held its July interest rate meeting on the other side of the ocean and announced that it would maintain the benchmark interest rate unchanged, but clearly released a signal that there was a high probability of a rate cut in September.

In the past month, the yen has risen by about 8% against the US dollar. The further narrowing of the US-Japan interest rate gap means that the yen carry trade model, which was previously favored by large funds, has reached a turning point, and the yen-based carry trade has been widely liquidated.

In the two trading days after the announcement of the rate hike, the Japanese stock market plummeted continuously. On August 5, the circuit breaker mechanism was triggered twice, setting the largest single-day drop in eight years.

The end of the yen carry game

Carry trade refers to a transaction in which a low-interest currency is exchanged for a high-interest currency, and then the foreign exchange lock-in cost is deducted to obtain a higher return than holding the low-interest currency.

Due to the long-term low interest rate, the yen has maintained a high interest rate gap with the interest rates of major economies in the world, becoming the main lending currency in global currency carry trades.

After the Japanese economic bubble burst, in order to stimulate demand, Japan's interest rates continued to fall. In July 1991, in order to stimulate the economy, the Bank of Japan began to cut interest rates, and the discount rate dropped from 6% to 0.5% in September 1995.

After Japan introduced the policy target interest rate in 1998, the interest rate further declined, and in September 1999, the interest rate was reduced to 0% for the first time, becoming the world's first major economy to implement zero interest rates. The extremely low borrowing cost established the yen as the main lending currency for global carry trades.

Fu Peng, chief economist of Northeast Securities, pointed out that Buffett's transaction of borrowing yen to buy Japanese trading companies is a typical case of the most certain carry trade, which completely hedges the risk/return of the yen exchange rate and focuses on the cash cow of the stability of large Japanese trading companies.

Specifically, Buffett, with Berkshire Hathaway as the main body, bet on the depreciation of the yen, issued yen bonds many times since 2019, and invested the borrowed yen in the "five major trading companies" with high dividend returns, including Itochu Corporation, Marubeni, Mitsubishi, Mitsui and Sumitomo. In the rising exchange rate of the US dollar against the Japanese yen, Buffett can be said to have acquired the stocks of the "Five Major Trading Companies" with extremely low-cost funds, and these holdings can cover or even exceed the interest costs of borrowing. Therefore, Buffett's investment in Japan is considered a "empty-handed white wolf" strategy.

Most of the world's "smart money" also followed the choice of the stock god Buffett, which also made the Japanese stock market soar and set new highs since 2022.

But the Bank of Japan, which has always been known for its unexpectedness, announced an interest rate hike at the end of July, ending the carry trade game. In the past month, the yen has risen by about 8% against the US dollar. The Bank of Japan further raised interest rates, the Federal Reserve is on the way to cut interest rates in September, and the further narrowing of the US-Japan interest rate gap means that the basis of the yen carry trade model no longer exists.

In panic, the Japanese stock market plummeted for three consecutive trading days, and the circuit breaker mechanism was triggered twice on August 5. As of the close, the Nikkei 225 index fell 12.4%, the biggest drop since October 1987.

Market sentiment took a sharp turn for the worse

The Bank of Japan flapped its butterfly wings, and the United States across the ocean resonated.

On July 31, U.S. time, the Federal Reserve’s July interest rate meeting resolution was settled. Although it did not announce a cut in the benchmark interest rate, at this meeting, the Federal Reserve almost sent a clear signal to the market that it would start the first interest rate cut in September.

However, such market performance was later verified to be a flash in the pan. The day after the Federal Reserve’s interest rate meeting, U.S. stocks began to plummet. The most direct cause was the July ISM manufacturing data released on August 1, which was only 46.8%, lower than the market’s previous expectations. The index reflects the factory activity in the United States and is generally considered to be a signal of economic recession.

Subsequently, the non-farm payrolls data released on Friday continued to increase investors' concerns. The July data showed that the US unemployment rate rose to 4.3%, the highest level since 2021. Combined with the number of first-time unemployment claims in the week announced the day before, which hit the highest level since August 2023, it showed that the US job market began to show obvious signs of slowing down.

Market sentiment took a sharp turn for the worse, and the original "optimism caused by interest rate cuts" instantly turned into "panic selling related to recession."

Some analysts began to criticize the Fed's slow monetary policy shift and missed the best time to avoid a hard landing of the economy.

Some economists believe that the Fed itself has fallen into a very passive situation. On the one hand, the Fed has repeatedly publicly emphasized that it must rely on economic data to make corresponding decisions. On the other hand, due to the significant lag of economic data, if the Fed fully follows the economic data to make corresponding monetary policy adjustments, it will inevitably be half a beat slower. Now the facts are developing towards a situation that is increasingly unfavorable to the Federal Reserve.

After the economic data showed obvious weakness and the Federal Reserve made it clear that there is a high probability of starting a rate cut cycle in September, the market has formed a new round of expectations for the Federal Reserve's rate cut. Investors expect that the probability of the Federal Reserve directly cutting interest rates by 50 basis points instead of 25 basis points in September has increased significantly.

During the earnings season of the US stock market, some technology giants that have already announced their earnings, such as Microsoft and Google, have maintained a solid performance fundamentals, but the new businesses related to generative AI that investors had high hopes for have not increased significantly in revenue and profit, but capital investment is still growing significantly. This reflects that the leading companies are still in the "arms race" stage, and the real added value generated by generative AI has not yet been fully reflected in the financial performance, which has also caused investors to begin to reposition the valuation of related listed companies.

The latest second quarter financial report released by Berkshire Hathaway, owned by "stock god" Buffett, shows that Buffett significantly reduced his holdings of Apple, his largest holding, by nearly 50% in the quarter, while cash reserves reached a record high of US$276.9 billion, a significant increase of 46.5% from the first quarter. The "stock god" who has been in the U.S. stock market for more than half a century and has remained unbeaten may have noticed the market abnormality in advance.