Nikkei's Black Monday 2.0 Triggers Contagion Talk

In this way, perhaps it's best to think of the carry trade as akin to the shark from“Jaws.” The recurring theme of Steven Spielberg's 1975 film is that the shark will always reappear when it's least expected to - and with exponentially growing ferociousness.

Just because the yen's rally surrounding the BOJ's rate hike hasn't sunk a bunch of big hedge funds yet doesn't mean the threat is gone. To the contrary, BOJ Governor Kazuo Ueda hinted at more rate hikes to come in the months ahead.

At the same time, Japan's Ministry of Finance has been interviewing aggressively below the surface. These yen purchases, coupled with prospects for more BOJ tightening, could send the yen back to levels not seen in decades.

No one can say how destabilizing that might be. Since 1999, the BOJ has held rates at or near zero. It's been toying with quantitative easing since 2001. The upshot of all this free money decade after decade is that virtually every sector of Japan's economy is now addicted.

Take Japanese government bonds (JGBs), which are still the biggest financial asset held by, well, everyone. If JGB yields rise toward 2% or 3%, banks, insurance companies, pension funds, endowments, the postal system and the growing ranks of retirees would sustain painful losses.

This mutually assured destruction dynamic has dissuaded the BOJ from doing exactly what Ueda did last week. Now that the BOJ has waded into these shark-infested financial waters, it's impossible to know where big risks might surface.

Granted, there are valid reasons why the BOJ feels the need to tap the brakes. It's realizing that 20-plus years of weak yen policies did more to deaden Japan's animal spirits than revive them.

Ultralow rates reduced the urgency for Tokyo to raise Japan's economic game. The resulting plunge in the yen relieved pressure on corporate chieftains to innovate, restructure and swing for the fences. It also has Japan importing inflation via elevated energy and food prices, damaging household purchasing power.

Yet Ueda has started the normalization process that Japan Inc. long dreaded. It is upending foreign exchange markets in unpredictable ways. And putting asset markets everywhere at risk. Perhaps grave risk, if Team Ueda overplays its hand in tightening.

“The pivot towards a more hawkish policy stance by BOJ is adding to the general pressure on risk assets globally,” says Carlos
Casanova, economist at Union Bancaire Privée.“This shift comes as Japan moves away from its decades-long ultra-loose monetary policy, contributing to increased market volatility and uncertainty.”

The yen appreciated after the tightening move and“more volatility is expected,” Casanova says. But, he adds,“the domestic economy remains sluggish, while US demand is showing signs of softening. With expectations building for a Federal Reserve cut in September, the weakening yen tailwind is likely to pause. With valuations now reaching the upper end of their range - about 17.5 times earnings - investors will need to see upside surprises in revenues and earnings to drive further gains.”

Udith Sikand, analyst at Gavekal Research, says“yen-funded carry trades causing a 'snowball effect' for other asset classes.”He adds that such“self-reinforcing declines are usually only broken when macro fundamentals decisively shift , or policymakers step in to correct a problem.”

As Sikand explains,“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 pinned short rates at zero for years, while making exhaustive efforts to suppress longer-term government bond yields. Carry trades work so long as the funding currency depreciates, or at least remains stable. An appreciation of the funding currency is the death knell of such trades.”

It follows that the yen's surge“has triggered margin calls for yen-funded speculators,” Sikand says.“It's hard to pinpoint the overall size of these long-short positions but anecdotal evidence suggests that the retreat of high-yielding currencies like the Brazilian real and Mexican peso is down to this effect, along with the sell-off in US tech stocks .”

Adding fuel to the selloff are concerns about US employment growth, with a dose of Warren Buffett tossed in.

Goldman Sachs economist Jan Hatzius says the odds of a US recession have jumped to 25% from 15%. Generally, he notes,“we continue to see recession risk as limited” because of a dearth of serious imbalances. Even so, the outlook is becoming more uncertain.

Some think US worries are overdone. George Lagarias, chief economist at Mazars, argues that falling stocks are“not due to an impending recession. Stocks are naturally correcting, and bonds are rising due to worse-than-expected macroeconomic data.”

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Lagarias adds that“assuming that the Fed acts quickly enough so that a risk assert correction doesn't threaten an actual recession, a further correction could thin out the market and allow investors to re-deploy cash at more reasonable valuations.”

Yet“one very important difference in 2024 is [the] extreme degree to which risk assets have front-run Fed cuts,” says Bank of America Corp economist Michael Hartnett.

Meanwhile, news that Buffett's Berkshire Hathaway sell nearly half of its massive stake in Apple Inc. The Omaha-based conglomerate offloaded a little more than 49% of its stake, a transaction that spooked US markets.

In Japan's case, the trouble is that there's no blueprint for what Ueda is trying to pull off. The BOJ tried it back in 2006 and 2007. Back then, the central bank managed to hike rates twice to 0.50%. Japan slid toward recession soon afterward, angering the political establishment.

Ueda would almost surely experience his own torrent of public criticism as growth contracts and the stock market plunges. Will he be able to weather the storm? It's anyone's guess. But all global markets can do is hope the BOJ gets the magnitude, timing and sequencing of rate hikes right.

Japanese government spokesman Yoshimasa Hayashi says Tokyo“will continue to stay on its toes and monitor market developments with keen interest.”

He added that“we're aware there are various evacuations regarding the stocks plunge this time around, and about the status of the Japanese economy, but the government will continue its efforts to completely break free of deflation and to transition to a growth-driven economy.”

The question is whether a surging yen triggers the domino effect that investors have long feared. That may not come to pass, meaning fears about the yen-carry trade blowing up are overdone. It's just as likely, though, the shark will reappear in short order and spook traders around the globe.

Follow William Pesek on X at @WilliamPesek

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