I had a different post that I was going to send out for the month, but I opted to rewrite it this weekend considering the most recent actions that we’ve seen in the market. This felt more relevant to the situation at hand. We haven’t had volatility in a really long time and on some level, it is nice to see the markets move and go through a correction.
So, what’s the root cause? There are several possible explanations:
- The lower-end consumer is now feeling the squeeze of higher inflation that includes living costs, interest rates, taxes, and insurance payments. All while their wages are not rising as fast as they were.
- The sudden rise of the Japanese yen as the carry trade implodes in just three weeks.
- Fear of a Middle East conflict.
- Political uncertainty with the assassination attempt on Trump and sudden withdrawal of Biden and rise in polls for Harris.
As I mentally evaluated all of these explanations this weekend, I was left with the feeling that the implosion of the Yen is the most likely cause. It isn’t to say that recent US economic data hasn’t been weak or middle east tensions haven’t grown or political uncertainty has taken over the airwaves, in fact, they are all issues. But those issues have been brewing for a while. The Yen has been the biggest change in the market in the past few weeks.
Japan’s debt market has long been an anchor for global investors due to its status as a funding source for carry trades. This is due to the Bank of Japan having short rates near zero for years which is because of their massive debt problem. These types of carry trades work as long as the currency continues to depreciate or at least remain stable. Once the currency appreciates, the trade usually blows up. The Bank of Japan has been trying to stabilize their currency for weeks and finally stepped in to stop the depreciation. This happened a few weeks ago which coincided with the weakness that we are seeing in the US markets.
If the root cause of market volatility is actually the yen appreciating and blowing up other markets, we have to start considering what would end the volatility. As I outlined it this weekend, I came up with four possibilities:
- The remaining yen carry trades get unwound. It is extremely difficult to determine the actual size of the yen funded trade that’s out there. Some estimated it to be close to $3 trillion. Regardless of the size, it will take time (weeks?).
- The Japanese government will step in to stop the appreciation of the yen. For the past couple months, the Japanese government including the Bank of Japan have talked about stopping the depreciating yen. This would be a complete pivot over the messaging that they’ve been sending but it is clear that the yen is appreciating much faster than intended. This would have the most immediate impact on markets.
- The US Federal Reserve cuts interest rates faster than expected. It is already expected that the Federal Reserve will begin interest rate cuts in September, but could they make an emergency cut? It’s doubtful that the Fed moves before September in my opinion.
- A US recession. I have long argued that stagflation is on the horizon for the US. With unsustainable debt levels and out of control fiscal spending, it seems inevitable. To be up front, I have thus far been wrong on my recession call. Regardless, this will take longer to develop as recessions don’t happen overnight. This means that under this scenario we could see volatility for the significant future.
In the near term the most likely possibility is some sort of intervention from the Japanese government that is possibly supported by US authorities to halt the rise of the yen. This would have the most immediate impact to stabilize markets.
