A Deeper Look at Japan and the Yen

Stocks took a deep breath Tuesday, with the S&P 500 clawing back 1.7%.^[i] This is not the end of volatility. It is a day of upward volatility after three days of the downward kind. It is entirely possible there will be more choppiness ahead—these things are impossible to time precisely. So steel yourself and stay cool. And for today, let us take a deeper look at one of the more complex stories accompanying stocks’ swoon.

This story: Japan. The nexus of the decline, with Japanese stocks enduring a swift tumble into bear market territory. As Exhibit 1 shows, painful as the ride has been for US and European stocks, Japan has taken an even greater sucker punch—in both yen and dollar terms.

Exhibit 1: Japan’s Jarring Ride

Source: FactSet, as of 8/6/2024. MSCI Japan Index total return in yen and MSCI Japan and World Index returns in US dollars with net dividends, 3/28/2024 – 8/5/2024.

Headlines pin Japan’s drop on the Bank of Japan’s (BoJ’s) rate hike—from 0.10% to 0.25% last Wednesday—and plans to halve the amount of monthly long-term bond purchases by March 2026. The yen strengthened in response to this, which headlines say will whack exporters, property firms, hotels and other companies that benefit—in theory—from a weaker currency. Oddly, in the weeks leading up to the rate hike, headlines said a stronger currency would benefit domestically focused businesses by relieving cost pressures on households, boosting consumer demand. But that narrative seems to have bitten the dust for now: Sentiment has morphed from winners and losers to everyone loses. Such indiscriminate panic and morphing fear is a correction hallmark.

Many also blame the BoJ for steep declines across Europe and the US, arguing the weak yen was propping up stocks outside Japan. This allegedly happened two ways. One, Japanese investors were supposedly concentrated in overseas stocks to escape their own weak currency, pumping up the S&P 500 and its giant Tech and Tech-like stocks as well as European benchmarks.

Two, and the more complex item: the yen carry trade. It works like this:

1. Western investors borrow yen in Japan at near-zero interest rates.
2. They move the money out of Japan and convert it to dollars, euros, pounds, Swiss francs, or, or, or.
3. They may hedge this, then invest in stocks, bonds or other securities in their country of choice.
4. As the security rises, they profit off the price movement.
5. As the currency strengthens, they also profit off its movement versus the yen (less any potential hedging costs or limits).
6. They watch Japanese rates and the yen like a hawk in hopes of finding the perfect exit before Japanese rates rise much and the yen re-strengthens.

With Japanese rates and the yen up in recent days, analysts suspect investors are unwinding many of these carry trades—that is, selling their US/eurozone/British/Swiss/whatever assets, converting their money back to yen, and sending it back to Japan to repay the loans. At the same time, Japanese investors are allegedly yanking their money out of international stocks and bringing it home so they don’t get hammered if the yen strengthens further (in which case, their dollars/euros/pounds/francs/etc. would buy fewer yen when repatriated).

All of this selling is supposedly hitting Western stocks, adding to pressure from renewed recession fears after Friday’s jobs report. There is also talk of a vicious circle of forced selling—in which market declines force investors to sell to cover leveraged positions, driving more declines, driving more selling, lather, rinse, repeat.

We think it is fair to say traders are probably unwinding some of their carry trade positions. Experience tells us it normally happens when the yen strengthens after a long weak spell. We saw it in the mid-2000s, for instance. But we also suspect a lot of it is a knee-jerk reaction to the volatility, rather than a sea change. For one, the yen is currently trading around 144 to the dollar. That is stronger than the 161 it hit in early July, around the time Japanese stocks peaked. But it remains weak relative to history. As we noted yesterday, when the yen hit this level back in January, everyone bemoaned it as a four-decade low. That people now call it “strong” is a sign that sentiment is out of wack—a signpost of the myopia that reigns when volatility spikes.

Two, we aren’t sure what the fundamental case for the yen to strengthen meaningfully from here would be. For the most part, currencies follow interest rates, with money going where yields are—and are expected to be—higher. The chatter today says Japan will receive global currency flows because the BoJ is hiking while Western central banks are cutting. Those observations are generally true enough, but the level of rates matters. Japan’s policy rate, as we mentioned earlier, is now 0.25%. The fed-funds rate is over 5 percentage points higher, and the Fed hasn’t cut yet. The UK’s Bank Rate, after last week’s cut, is 5.0%. The ECB’s policy rate is 4.25%. Long-term rates are also much higher in the West. Note, too, that the BoJ still plans to buy Japanese Government Bonds. This is a taper, a slowing of bond purchases. It is not quantitative tightening, the unwinding of bonds the bank owns through either selling them or letting them mature. Continued buying still puts downward pressure on long rates, a point getting lost in the coverage.

There is also a logical disconnect in the bearish sentiment surrounding the BoJ. Until last week, many cast the bank’s supposedly ultra-loose policy as massively bullish for Japan and the world. But if you take all the prevailing narratives at face value, there is too much cognitive disconnect. If near-zero rates and quantitative easing were massively bullish for Japan—and driving Japanese stocks to chart new high after new high this year—then how were they also causing investors to flee Japan in search of higher yields and currency appreciation elsewhere? How could institutional money be flocking to and running from Japan at the same time, for the same reason? The world can’t herd in opposing directions at once with the same motivation underpinning both ends. You can’t have it both ways.

Was there probably some carry trade activity? Sure. And overseas investments from Japanese institutions and households? Likely. And were Western investors bullish on Japan? Yah—there was a ton of that this year as Japanese benchmarks passed the Nikkei bubble’s peak. And are some of these trades now reversing as people react to volatility and traders’ sell indicators fire? Seems probable to us.

But don’t confuse this normal volatility and behavior with a fundamental sea change in how markets are working. Yen-based tactics were just one contributor to global stock demand, likely one at the margin—not central. Soon enough, as the investing world realizes it overreacted, this should be clear enough.