Global stock markets rout — what did Japan and the yen have to do with it?

Stockbrokers around the world woke up to one of their worst days on August 5. Japan’s benchmark Nikkei 225 index plunged 12.4%, while the Japanese yen strengthened to a seven-month high against the US dollar.

Soon, it was as if a domino effect had been kickstarted. By the end of the day, South Korea’s Kospi was down 9.12%, Taiwan’s Taiex index 8.35%, and India’s BSE-100 2.77%.

The US stock market was no better. The S&P 500 slid 3%, its worst day since September 2022. The Dow Jones Industrial Average declined 2.79%. The tech-heavy Nasdaq Composite Index lost 4.05%.

According to Bloomberg, the global stock market rout wiped off $6.9 trillion in market capitalization.

The stock market meltdown — what and why

But what did Japan have to do with all this?

Its central bank, which had kept the interest rate at 0-0.1% for the last 17 years, decided to raise it to 0.25% the preceding week.

As a result, the Yen — which had fallen to a near-four-decade low last month — began to appreciate.

This affected the carry trade.

A carry trade happens when an investor borrows money in a low interest-rate currency (in this case the Yen), converts it into another currency, and uses it to invest in assets with an interest rate above zero to make a profit.

This was so popular that according to data from the Bank for International Settlements, cross-border yen borrowing had risen by $742 billion since end-2021.

However, carry trade remains profitable only as long as the currency the money was borrowed in does not appreciate, the interest rate remains zero, and the assets invested in retain their value.

After the Japanese central bank decision, two of these happened. Borrowing was no longer interest free, and the Yen appreciated, shrinking the investors’ profit margins.

For example, an investor had borrowed money in Yen when 1 USD = 165 Yen. However, the currency rapidly appreciated to 145 Yen per dollar. Irrespective of the returns, the investor will face a cross-currency loss.

This led to an “unwinding” as some traders started selling off their assets and repurchasing the Yen to pay back their loans. However, this increased demand for the Yen led to it appreciating even more.

But not all of the stock market rout had to do with Japan’s central bank and the Yen.

Data shared by the US Labor Department showed that the country’s unemployment rate rose to a three-year high, which led to fears that the world’s largest economy was heading for recession. And tech companies’ results were underwhelming.

All of this contributed in varying degrees to the global stock markets rout.

The good news, however, is that the effect of the carry trade unwinding, weak US data, and disappointing tech results is waning with analysts saying investors are finding their footing again and the “shake up” will be limited.