When the distracted investor returns from his leave, he may well think that nothing has happened in the financial markets while he is away.
Indeed, the changes recorded since the beginning of August do not show anything exceptional. Yet, around 5 August, financial markets experienced strong turbulence, with some of them losing out considerably. But the horizon soon cleared, like a summer storm. What happened?
Epicentre in Japan shakes everywhere
In a single session on 5 August, the Tokyo stock exchange benchmark lost 12%, a performance comparable to the black Monday that marked the crash of October 1987 (14.9%). Although the decline was less significant elsewhere, it was substantial everywhere.
In Asia first, with the Kospi of the Korean stock exchange losing 8%. In the US, as in Europe, declines of 2.5% to 3.5% were the norm. A serious call to order after months of almost uninterrupted equity market growth.
Of course, the bond markets have benefited from these turbulences and the flight to haven.
The US 10-year rate, which ended in July at around 4.1%, fell rapidly to 3.7%, a move followed remotely in Europe, where bond rates also declined.
A sage in the United States
Initially, it was the US labour market figures that were singled out as being at the root of the sudden mistrust among investors. In July, job creation in the US weakened sharply and the unemployment rate rose to around 4.3%. Figures that suggested a lower growth dynamic, were published just after the Fed decided to keep its key rates unchanged, postponing the timing of a first decline to 18 September. Suddenly, this date seemed too late to investors, who were worried about the real possibility of recession in the US.
The feeling of having eaten his white bread was reinforced by Warren Buffet, reference investor. On 3 August, its holding company Berkshire Hathaway announced the sale of almost half of its position in the giant Apple. More broadly, it sold over USD 75 billion in shares in the second quarter. Investors have concluded that the Omaha sage had guessed a major risk of correction for the market and rushed towards an exit.
A “Made in Japan” storm
The weakening of the labour market and the taking of profits by Warren Buffett have certainly played a role, weighing on the morale of investors. But the root causes of the strong shocks experienced in the markets are to be found far from there, on the Japanese archipelago.
At its meeting on 31 July, the Bank of Japan raised its key interest rates for only the second time in 17 years to 0.25%. But more importantly, while his speech is often cautious, his governor was quick to declare that he was open to further rate hikes in the future.
Such a statement surprised investors. The latter expected to see the interest rate differential that separates Japan from the US eroded by the taste of the cuts in US policy rates... but they did not expect the Bank of Japan to stay on a bullish policy – opposed to that of the Fed, therefore - rapidly reducing this same differential. Such a decision would have heavy consequences for carry trade and therefore for the financial markets
Carry-trade, an inexhaustible source of liquidity?
Carry-trade is the borrowing of capital at a reduced rate before investing it elsewhere, at a higher yield, which allows one to pocket a nice profit in the process.
The financial sector does so when the yield curve is steep, borrowing at low rates in the short term and then issuing long-term loans at higher rates. The big players in the finance sector are pushing the logic further: they borrow where credit is cheaper and then invest where returns are higher.
Since the wave of inflation has pushed most major central banks to raise their policy rates, making credit more expensive, Japan has remained the only major economy that continues to offer zero-interest financing. As a result, the yen has become the reference currency for carry trade and an enormous source of liquidity for financial markets. Some months ago, it was still possible to borrow yen at zero interest rates and then sell it immediately, investing in US debt with a yield of more than 5%. Add to this that the more popular the carry, the more the yen was sold and weakened against the US dollar, making the operation even more attractive.
With the announcement of upcoming interest rate hikes, the Bank of Japan has thrown sand on this well-oiled gear. On the one hand, the rate differential would reduce faster than expected, reducing the window of opportunity for carry traders. On the other hand, it has put the yen on an upward trajectory, meaning that in the future it would take more USD or € to repay the starting loan. The carry trade was therefore becoming less profitable and more risky. With two major consequences. First, there is a sudden reduction in the liquidity available in the markets. Then, faced with the sharp yen rebound in early August, investors rushed to close their positions, selling as quickly as possible. In the middle of August, a period known for its low volumes and many actors were absent, this movement was enough to cause strong jolts. The reason why these were quickly halted was simply because the Bank of Japan had been quick to apologize to investors for the turmoil, assuring them that in the current state of markets further increases in policy rates were not a matter of urgency.
Markets have therefore quickly recovered. The US economy may slow down, but liquidity will remain abundant thanks to Tokyo, and carry-trade can be reactivated.
Strong but transient, the summer storm reminds us that financial markets remain nervous. They started in 2024 anticipating a sharp easing of credit conditions, with six to seven key rate cuts expected in the US. They always make themselves wait. Despite this, the markets are enjoying a good year (+17% year-on-year, in €, for the US stock market, +8% for the Japanese stock market, and +4% for the euro area markets), driven by the euphoria around the Magnificent seven and artificial intelligence.
But at this point, investors are hesitant, looking for new growth drivers and differentiating between different markets, depending on the quality of companies present, governance and economic prospects. In such circumstances, it is essential to diversify your portfolio.
