Japan's Stock Market Crash
On Monday, August 5, 2024, Japan’s Nikkei 225 index plunged 12.4%, its biggest single day drop since 1987. And so what exactly happened?
First, you need to understand what a carry trade is.
Simply put, carry trade is when you borrow money in a country where interest rates are low and invest it in another country where interest rates and investment returns are higher.
For most of the last 25 years, the favored country to borrow money from is Japan, which has kept interest rates close or to zero. While inflation posed concerns in most other countries like the US and Europe, leading them to raise interest rates to combat it, Japan had the opposite problem. It kept borrowing rates low to encourage economic growth.
You could borrow money for next to nothing in Japan and invest it in US Treasury Bonds, which yielded a 5% return. Kind of a no brainer. And that’s the conservative route; you could also invest in other securities which had even higher returns.
However, this isn’t risk free. Imagine if you borrow 1000 yen when the exchange rate is 200 yen to 1 USD, effectively borrowing $5. However, the yen suddenly appreciates significantly against the USD, making it much more expensive to pay back the loan. If the new exchange rate is 100 yen to 1 USD, we would need to pay back $10 now for the same loan.
This is exactly what happened. Last week, the Bank of Japan raised interest rates for the second time since March, which pushed the yen higher. [1] Additionally, the Fed strongly hinted last week that it would cut interest rates soon, which weakened the dollar.
This meant carry trading wasn’t as lucrative anymore, and if you were a carry trader, you would try to unwind these positions. Problem was, so was everyone else.
We must also keep in mind that carry trade involves borrowing money, which means it's a leveraged position.[2] When losses start to accrue, lenders will demand that you provide additional cash to cover potential losses. This is known as a margin call.[3] This means investors start selling stock to raise cash, or closing out on their position entirely.
This leads to a trickle-down effect. The riskiest investors will start liquidating, which creates losses for others, and as a result, those people have to sell their assets to cover their margin calls, and so on, and the stock market plummets.
[1] Why does raising interest rates appreciate currency?
Short answer is that when interest rates increase, bonds and savings accounts, which now offer higher yields, become more attractive to investors. To invest in these higher-yielding Japanese assets, investors need to purchase yen, thus increasing demand for the currency, and since there’s only a fixed supply of yen, the price of yen increases.
[2] What is a leveraged position?
Leverage position means borrowing money to amplify your potential returns on an investment. For example, you believe that a stock is going to increase 50% in the next year, but you only have $100k to invest. Without leverage, your profit would only be $50k.
Instead, you decide to use leverage and borrow $900k. Now, you can invest $1 million in this stock, yielding a $500k profit (minus interest rates on that loan), which is 10x what you you could make by yourself.
However, this also works in the opposite direction if the stock decreases. If the value of your stock drops by 50% instead, the value of your investment is now worth $500k. You still owe the lender $900k (plus interest), so even after selling all the stock you have, you are now over $400k in debt.
High risk, high reward.
[3] What is a margin call?
A margin account is a type of brokerage account that consists of securities bought with a combination of the investor's own money and borrowed funds. When the value of the account falls below a certain threshold, usually due to a losing trade, the lender will require you to deposit more money or securities to bring the account's value back above the specified threshold.