From July 2024 to the present, the global financial market has ushered in a new wave of turmoil. The main manifestations are as follows: First, the global stock market represented by the US and Japanese stocks has plummeted, and the VIX index, which reflects the degree of stock market volatility, has surged; Second, the global risk-free long-term interest rate has fallen, for example, the yield on 10-year US Treasury bonds has dropped from around 4.20% to around 3.75%; Third, the US dollar index has fallen, with the most significant decline in the US dollar against the Japanese yen. For example, from July 10 to August 5, the exchange rate of the US dollar against the Japanese yen fell from 161.73 to 143.95, with a depreciation of 11%. In addition, the CNH exchange rate of the US dollar against the Chinese yuan has also fallen significantly; Fourth, the global prices of gold and crude oil have fallen significantly; Fifth, all the above indicators have shown a deep V-shaped trend of sharp decline followed by a significant rebound, which usually means that short-term financial indicators have overshot beyond the extent that can be explained by fundamentals.
The reasons for the recent turmoil in the global financial market, in my view, mainly have the following three main explanations.
First, the Bank of Japan's interest rate hike led to a large-scale liquidation of the yen carry trade. Driven by high domestic inflation, from March 2022 to July 2023, the Federal Reserve raised interest rates 11 times in less than a year and a half, with a total increase of 525 basis points. During the same period, due to sluggish economic growth, the Bank of Japan remained inactive. The above monetary policy differences led to a rapid expansion of the US-Japan interest rate differential, thus triggering a new round of yen carry trade.
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This round of yen carry trade can be roughly divided into three levels:
The first level of carry trade is that investors borrow yen and then exchange yen for US dollars to obtain the interest rate difference between the two, which results in a decline in the yen against the US dollar exchange rate; The second level of arbitrage trade is that investors borrow yen, exchange yen for US dollars, and then use US dollars to buy US stocks, which can enjoy the dual benefits of the US-Japan interest rate difference and the rise of the US stock market, resulting in a decline in the yen against the US dollar exchange rate and an increase in US stocks; The third level of arbitrage trade is that investors borrow yen with US dollars as collateral, and then use yen to buy Japanese stocks, which can enjoy the dual benefits of the US-Japan interest rate difference and the rise of the Japanese stock market, resulting in a decline in the yen against the US dollar exchange rate and an increase in Japanese stocks. In addition, investors will use leverage to amplify the return rate of the yen carry trade.
As shown in Figure 1, from 2022 to the present, the exchange rate trend of the US dollar against the Japanese yen and the trend of the US-Japan interest rate difference have shown a high positive correlation, and the interest rate difference usually leads the change in the exchange rate of the US dollar against the Japanese yen, which is evidence of the existence of the first level of arbitrage trade. As shown in Figure 2, from 2023 to the present, the positive correlation between the exchange rate trend of the US dollar against the Japanese yen and the NASDAQ index trend has significantly increased, which is evidence of the existence of the second level of arbitrage trade. As shown in Figure 3, from 2023 to the present, the positive correlation between the exchange rate trend of the US dollar against the Japanese yen and the Nikkei 225 index trend has significantly increased, which is evidence of the existence of the third level of arbitrage trade.
The sharp depreciation of the yen against the US dollar caused by the new round of yen carry trade is beneficial for boosting Japanese exports and promoting the rise of the Japanese stock market, but it will worsen Japan's trade conditions and bring import inflation pressure. Against this background, the Bank of Japan began to respond by raising interest rates and intervening in the foreign exchange market. On the one hand, the Bank of Japan raised interest rates once in March and July this year. In March, the Bank of Japan raised the policy interest rate from -0.1% to 0-0.1%, which was the first time the Bank of Japan raised interest rates since February 2007. On July 31, the Bank of Japan raised the policy interest rate from 0-0.1% to 0.25%, and this interest rate hike directly led to the escalation of this round of global financial turmoil. On the other hand, the Bank of Japan entered the foreign exchange market for intervention several times in May and July this year.
The interest rate hike and intervention by the Bank of Japan led to a significant narrowing of the US-Japan interest rate difference. For example, the difference in the yield of 10-year US and Japanese government bonds narrowed from 381 basis points on April 30, 2024, to 283 basis points on August 2, a decrease of nearly 100 basis points. The significant narrowing of the interest rate difference led to losses for investors who entered the carry trade with high leverage later, forcing them to liquidate their positions. The liquidation operation will lead to a decline in the exchange rate of the US dollar against the Japanese yen, as well as a decline in US and Japanese stocks. Once the exchange rate of the US dollar against the Japanese yen falls, it will expand the loss range of carry traders, thus triggering a larger scale of liquidation. This forms a new vicious cycle.Second, recent data indicates that the pressure of economic recession in the United States is intensifying, and the market is concerned that if the Federal Reserve does not cut interest rates in time, it may trigger a large-scale economic recession.
In May, June, and July 2024, the unemployment rates in the United States were 4.0%, 4.1%, and 4.3%, respectively. Compared with 3.4% in January and April 2023, the unemployment rate in July increased by nearly 1 percentage point. In July 2024, the U.S. CPI year-on-year growth rate dropped to 2.9%, which is the first time the data has been below 3% since April 2021. In the same month, the U.S. core CPI year-on-year growth rate (3.2%) also reached a new low since May 2021.
In July 2024, the decline in the U.S. unemployment rate triggered Sam's Law. Sam's Law refers to the situation where if the average of the U.S. unemployment rate in the most recent three months is more than 0.5 percentage points higher than the low point in the past 12 months, it signifies that the United States has entered the early stage of an economic recession. Since 1950, Sam's Law has been triggered a total of 11 times, and its effectiveness has been verified to be as high as 100%. For example, the law was triggered for the 10th time in January 2008 and for the 11th time in April 2020. In July of this year, the law was triggered for the 12th time. There are two reasons why Sam's Law has a high accuracy rate: on the one hand, in the early stages of a recession, unemployment statistics tend to underestimate the unemployment rate; on the other hand, an increase in the unemployment rate leads to a slowdown in real wage growth, which reduces total demand. The reduced total demand will further lead to an increase in the unemployment rate and a slowdown in real wage growth. Therefore, the unemployment rate is a variable with a self-perpetuating trend, and when it begins to rise significantly, it often continues to rise.
The market once worried that the Federal Reserve's first interest rate cut would be postponed to December of this year. After the data for July came out, the market now believes that the probability of the Federal Reserve cutting interest rates in September this year is almost 100%, and the market has increased its judgment of the cumulative interest rate cut of 50 basis points within the year to 100 basis points. Therefore, if the Federal Reserve cuts interest rates later than expected or the magnitude of the cut is weaker than expected, it may lead to new turmoil in the financial market.
Third, investors' concerns about the sustainability of U.S. high-tech stock prices are continuously increasing.
As is well known, the bull market in U.S. stocks in the past few years has been largely driven by the so-called Magnificent Seven (Mag7), and is largely related to the market's optimism about artificial intelligence technology. In July of this year, Goldman Sachs released a research report questioning whether the trillion-dollar artificial intelligence expenditure can bring growth in the operating income of related companies. This view has been echoed by many investors, leading to significant fluctuations in the stock prices of the Magnificent Seven in recent times, especially NVIDIA.
Where will the current global financial market turmoil go in the future? The author believes that in the short term, the peak pressure of yen carry trade liquidation has passed, and the U.S. economy still has a certain resilience, so the possibility of the current global financial market turmoil continuing to ferment and leading to a new round of crisis is low, but the increase in global financial market volatility is still a high-probability event.
Firstly, the peak pressure of yen carry trade liquidation has passed. Based on the current estimates of various investment institutions, the scale of yen carry trade is between 300 billion and 500 billion U.S. dollars, of which 150 billion to 250 billion U.S. dollars of funds are more active. Currently, JPMorgan and UBS believe that two-thirds of the yen carry trade liquidation has been completed, while Goldman Sachs believes that the liquidation trade has basically ended. In addition, according to the non-position data of the CFTC, the net short position of the yen reached a historical peak of 184,000 contracts at the beginning of July, and has decreased to 11,000 contracts by around August 6th.
Secondly, the probability of a soft landing for the U.S. economy is still high. First, although the U.S. unemployment rate has risen to 4.3%, from an absolute level, it is still quite close to the natural unemployment rate. In addition, the U.S. labor force participation rate rose to 63.2% in July, which is the highest level since March 2020, indicating that a large part of the labor force that once exited the labor force after the outbreak of the COVID-19 pandemic has returned to the labor market. Second, with the decline in inflation and core inflation rates, the space for the Federal Reserve to cut interest rates is expanding. The timing of the Federal Reserve's interest rate cuts within the year may be advanced, and the magnitude may be increased. Third, the current real expansionary strength of U.S. fiscal policy is still significant.
Lastly, although the probability of a global financial crisis is low, an increase in global financial market volatility is a high-probability event. First, considering the sharp contrast between the stock price performance of the Magnificent Seven and many traditional industries in the past few years, the author believes that skepticism about high-tech stocks such as AI will continue in the coming period, and there is a possibility that U.S. high-tech stocks may repeat the significant adjustment pattern of 2022; second, in the second half of this year, uncertainties about the U.S. election, the subsequent development of the Russia-Ukraine conflict and the Israel-Palestine conflict, may have a significant impact on investor sentiment; third, the pressure of high interest rates on the U.S. government's rigid interest expenditure is becoming apparent, and market concerns about the sustainability of U.S. sovereign debt are also intensifying; fourth, the Bank of Japan may continue to raise interest rates. In summary, safe-haven assets such as gold still have room for price increases in the future.Finally, the pressure for the depreciation of the Chinese yuan against the US dollar is expected to continue to ease. In the first half of 2024, the pressure on the yuan against the US dollar increased, which was reflected in the widening spread between the onshore and offshore exchange rates of the yuan against the US dollar, as well as the widening spread between the midpoint rate and the closing rate of the yuan against the US dollar. In the past month, as the US dollar index fell, both the offshore price and the onshore closing price of the yuan against the US dollar have significantly appreciated, and have essentially converged to the midpoint rate. The author believes that in the coming period, the midpoint rate of the yuan against the US dollar is expected to stabilize around 7.1, and the closing rate of the yuan against the US dollar is expected to converge to around 7.1-7.2.