A butterfly flapping its wings in Brazil could cause a tornado in Texas a month later.
On July 31, the Bank of Japan raised its policy rate from 0% to 0.1% to around 0.25%, the first rate hike since Japan ended its negative interest rate policy in March this year.
Over the past month, the yen has risen by about 8% against the dollar. As expectations of a narrowing of the U.S.-Japan interest rate gap grow, the trend of reversing carry trades is triggering a large-scale "liquidation" around the world.
Some financial markets around the world experienced Black Monday.
Japan's stock market experienced an epic plunge, with the Nikkei index plunging 9% and the Topix index triggering circuit breakers twice, marking the biggest single-day drop in eight years.
Stock markets in South Korea and Taiwan were not spared.
The Korean market also saw a sharp drop of more than 4% at the opening, and Samsung's share price fell by 5%, the biggest drop since 2020. The Korea Exchange initiated a temporary suspension of trading.
U.S. stock index futures continued to fall, with Nasdaq 100 index futures widening their losses to 2%. The U.S. 2-year Treasury yield fell 9 basis points to its lowest level since May 2023, and the U.S. dollar index fell to around 103. It can be foreseen that the U.S. stock market will be bloody again tonight.
However, the worst is still the crypto market.
Bitcoin once fell to around US$54,000, and Ethereum once fell to around US$2,100, with a single-day drop of nearly 20%. A liquidation of US$800 million in 24 hours took place, and the market value of the entire crypto market fell below US$2 trillion.
In retrospect, this global sell-off may have been caused by the reversal of yen arbitrage and the turbulent situation in the Middle East.
What is the Yen Carry Trade?
Currency carry trade is a type of carry trade, which means borrowing a currency with a lower interest rate and investing in financial assets with a higher interest rate or higher expected rate of return.
Since Japan's interest rates have been at extremely low levels for many years, market participants finance themselves by borrowing money at low interest rates in Japan, and then converting the funds into other currencies such as the US dollar to invest in assets in countries with high interest rates.
The peak of yen carry trade began in 2004. In order to stimulate economic recovery, the Bank of Japan implemented a "zero interest rate" policy from March 2001 to July 2006. On the contrary, during this period, European and American countries frequently raised interest rates, and interest rates continued to rise. Investors borrowed yen and bought high-interest currencies such as US dollars and euros in the foreign exchange market to invest in stocks, real estate and other markets, or directly purchased high-yield assets denominated in these high-interest currencies to make profits.
The yen carry trade has historically supported bull markets in global equities by enabling cheap currency funds to be invested elsewhere.
A typical case is that last year Buffett borrowed Japanese yen to buy stocks of Japanese trading companies and completely hedged the risk/return of the Japanese yen exchange rate, focusing on the stable cash cows of large Japanese trading companies.
The U.S. stock market has maintained a "long bull market" despite the impact of the U.S. dollar interest rate hike, and its continued rise to new highs is still due to the yen carry trade, which provides sufficient liquidity.
The same goes for Bitcoin, which is also a beneficiary of the long-term depreciation of the Japanese yen.
In May, BitMEX founder Arthur Hayes wrote an article bullish on Bitcoin, arguing that a weak yen could push Bitcoin to $1 million.
Arthur pointed out that the USD/JPY exchange rate is one of the most important global economic variables. The complex monetary policy interactions between China, the United States and Japan, as well as their profound impact on the global economy, affect the trend of the cryptocurrency market.
When talking about the situation that the yen keeps breaking new lows due to the widening interest rate gap between the US and Japan, Arthur mentioned that the Bank of Japan will not be willing to raise interest rates because the Bank of Japan is the largest holder of Japanese government bonds. When interest rates are raised, bond prices will fall, which means that the Bank of Japan will suffer the greatest losses. However, if the Bank of Japan does not raise interest rates and the Federal Reserve does not cut interest rates, the USD/JPY interest rate gap will still exist. When the USD yield is higher than the JPY, investors will continue to sell the JPY, causing the JPY to continue to depreciate.
“Bitcoin is the best performing asset in the face of global fiat currency devaluation, and they know it. When action is taken against yen weakness, I will mathematically predict how funds flowing into the Bitcoin complex will push the price to $1 million and possibly even higher,” Arthur predicted.
However, the development of the situation was beyond Arthur's prediction. The yen did not continue to depreciate. Instead, the Bank of Japan began to raise interest rates.
According to historical records, every reversal of the yen carry trade could trigger a crisis, because a major side effect of the yen carry trade is to fuel asset bubbles in related countries and markets, especially emerging market countries.
Massive amounts of Japanese yen funds are widely distributed in the world's stock market, foreign exchange market and commodity market, becoming an important force influencing the world's market situation. Its rapid flow in the global market has also cast many uneasy shadows on the international financial market. It is for this reason that the International Monetary Fund and the Bank for International Settlements have repeatedly reminded people of the dangers of Japanese yen carry trade.
The International Monetary Fund (IMF) has published a report on the relationship between the yen carry trade and the subprime mortgage crisis. The report points out that the end of the yen carry trade often leads to capital withdrawal, triggering a global decline in asset prices, and as financial institutions deleverage, it will lead to credit tightening.
Specifically, the impact of the reversal of the yen carry trade is mainly reflected in the following aspects:
Asset price volatility: The unwinding of the yen carry trade leads to a withdrawal of funds from high-yielding risky assets, which typically triggers a fall in asset prices.
Tightening of credit markets: When financial institutions began to unwind yen carry trades, they needed to reduce leverage by selling assets and repaying debts, which reduced liquidity in credit markets and further tightened credit conditions.
Changes in risk appetite: The "fear index" VIX index is negatively correlated with the scale of yen carry trades. When market participants expect low risk and high returns, the scale of yen carry trades increases, and vice versa.
The subprime mortgage crisis intensified: As financial institutions unwound their carry trade positions, prices of subprime mortgage-related assets fell further, exacerbating the credit market crunch and losses for financial institutions.
The recent sharp decline in U.S. stocks, led by the technology sector, largely reflects the massive reverse liquidation of carry trades.
According to a report released by Citi analysts Osamu Takashima AC, Daniel Tobon and Brian Levine, the threshold for the US-Japan interest rate differential for the dollar to turn downward after an upward trend was about 4.75%. Currently, the differential is about 5.25%. To reach this level, the Federal Reserve may need to cut interest rates three times, and the whole process will take about six months.
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