Financial markets have felt anything but robust recently. Investors are concerned about the economy, the possibility that the Fed may be behind on cutting rates, and some disappointing tech earnings. Ironically though, despite the market volatility last week, major indices were mostly unchanged from Monday to Friday. While market measures are down from their recent all-time highs, and there seems to be heightened market uncertainty, the S&P 500, Nasdaq, and Dow are still up 13%, 12%, and 6% respectively with dividends for the year. This is a good reminder that, while market swings can have an outsized impact on how we feel about our investments, it’s always wise to step back and look at the facts – and it’s especially helpful to put things into a longer-term perspective.
So why the recent volatility? In addition to uncertainty regarding certain economic and fundamental factors, it appears that technical factors – specifically the so-called Japanese ‘carry trade’ – may have worsened the recent pullback. Much has already been written on this topic in the financial news, yet it is an important example of how technical factors (coined “technicals” in financial jargon) can impact markets in the short run even as fundamentals drive returns in the long run. But what is a carry trade? And why is it being blamed for global stock market declines?
The Unwinding of the Japanese Carry Trade
While it may seem opaque at first, the concept of a carry trade is actually quite straightforward: A carry trade simply involves borrowing at lower interest rates and investing at higher interest rates, thereby earning the difference in yields. This also requires buying and selling currencies, since investors will often utilize government bonds around the world. In general, carry trades are more attractive when there is a large difference in interest rates and when currencies are stable.
Borrowing using the Japanese yen has been popular for decades since Japan’s interest rates have been extremely low. Until recently, the Bank of Japan’s policy rate had been negative since 2016, and had not been higher than 0.1% since 2008. In fact, the highest it has been this century is 0.5%. There were many reasons for low rates in Japan, including the risk of deflation, sluggish growth, and unfavorable demographic trends. This period is sometimes referred to as Japan’s “lost decades.”
But this all changed recently. Due to rising inflation, the Bank of Japan raised rates to 0.25%, while the Fed is expected to cut rates. Not only does this decrease the interest rate differential between the U.S. and Japan, but the Japanese yen has also strengthened over the past month, jumping dramatically overnight when market volatility hit. These market moves endanger the typical carry trade; the interest-rate differential shrinks while the borrowing currency becomes more expensive. In the graphic below, note the way the yen is typically quoted – the number of Japanese yen per U.S. dollar – so that a higher number represents a weaker yen.
Recent Volatility Has Been Worsened by Financial Leverage
On its own, the reversal of one trade does not usually trigger widespread concern, especially on a global scale. However, since carry trades often depend on borrowing, changes can have an amplified effect. This concept, known as “financial leverage,” has worsened market crises throughout history, including the 2008 global financial crisis, the 1997 Asian currency crisis, the collapse of Long-Term Capital Management, and even the stock market crash of 1929.
As the economist Hyman Minsky explained, “The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” In this case, the carry trade has a long history and is based on economic trends that have lasted for decades. The longer a trade works, the more willing investors are to steadily increase the size of their bets – just as a gambler does in a casino when they believe they are on a hot streak. Eventually, however, there is likely to be a “Minsky Moment,” whereby the unwinding of the trade is made more urgent by this leverage. Naturally, then, investors avoid the trade for some time, before eventually returning and beginning the cycle anew.
This concept of the ebb-and-flow of risk preference in financial markets is crucial for investors to internalize. It throws a rational light on the potential risks associated with excessive and unexamined optimism or simply doing more and more of whatever has been working in the recent past. Most recently, we saw this in 2021 during the so-called “everything rally” following the pandemic. These periods are characterized by excessive optimism, eventually detached from market and economic fundamentals. The concept also applies to individual securities. For example, take that stock you felt was a “must-buy” because its value had increased dramatically over the past couple of years. Can you honestly say that it’s still a good value? Or do you believe that it will continue to go up simply because it’s gone up in the past?
It’s important to keep in mind that adjustments – shocks – to different parts of the market are not unusual, and that not every source of fragility results in dramatic volatility. Many economic cycles exhibit periods of expansion and contraction without triggering a crisis on the order of 2008 or 2020. Indeed, last year’s banking crisis is a recent example of a serious issue that stabilized fairly quickly. As a result, while vigilance is always wise, it’s equally important for investors to maintain a balanced perspective, recognizing that markets are inherently flexible and have demonstrated the capacity to overcome even serious issues over time.
Market Pullbacks are Normal and Expected
Where do we stand at present? Stock market indices are still below their recent highs, and it’s possible that investor unease could continue. The Nasdaq is in correction territory, having fallen 10% from its peak, while the S&P 500 is only halfway to a correction. Still, history suggests that pullbacks and corrections are not only normal but can also be healthy as markets adjust to new economic, market, and company data. The above chart shows that the typical correction involves a decline of 14% on average, which then recovers within four months. A key observation for long-term investors is that the recovery often begins when investors least expect it. You just can’t call the turn.
While day-to-day swings can be unsettling, it’s far more important for long-term investors to understand market fundamentals. The unwinding of the Japanese carry trade may have resulted in shockwaves across global markets, but the situation already appears to be stabilizing. Focusing on the business cycle, corporate earnings, valuations, and other underlying market factors can help you to see near-term volatility in a less frightening light.
As always, if you have questions about your own long-term investment strategy or portfolio, reach out to your Griffin Black Advisor. We always welcome your questions.
