Market Turbulence
Reflecting on a wild week in markets and the implications
What a wild week in markets. I’ve been working on some other posts but thought I market update would be more appropriate and whether it changes my market outlook that I covered in my post Macro Blueprint and Backing The Fastest Horse published in late June.
Markets took tumble, there were sharp sell offs and plenty of liquidations. The top 7 stocks in the US erased $500 billion overnight. The Japanese stock market crashed with trading halted on the Major Index and the Korean stock exchange suspended trading.
The crypto market, known for its volatility, took a lot of damage. This tweet sums it up for me.
So what caused this sell off? The consensus view is that it’s the unwinding of the dollar Japanese Yen (JPY) carry trade. However, I agree with the take that this was sort of exaggerated by a couple of very weak prints from the US economy towards the end of July increasing the probability of a recession that had not been priced in. So it was kind of a mix of a recession fear stemming out of the US paired with the unwinding of the dollar JPY carry trade.
What is a carry trade? A carry trade is when you borrow a currency with a low interest rate and buy financial assets in another currency that yield more or have a higher chance of appreciating. When it comes time to repay the loan, money is lost if the currency borrowed appreciates relative to the currency of the assets you purchased. If the currency borrowed depreciates, money is made.
For 30 years, Japan maintained 0% interest rates, allowing investors to borrow yen at little to no cost and invest it globally in T-bills and a basket of risk assets. Investors benefited from the low borrowing costs and the frequent devaluation of the yen due to the Bank of Japan (BOJ) running the world's loosest monetary policy. As a result, their JPY loans depreciated relative to the USD or USD-denominated assets purchased, making it a win-win for them until now.
The BOJ has been able to conduct such loose monetary policies because Japan has always maintained very low inflation due to several interrelated factors like their aging population, shrinking workforce, high savings rate and other cultural and structural elements. Also, Japan is an export-oriented economy so they actually benefits from a weaker JPY (to an extent).
Recently, inflation began to surface in Japan, prompting the BOJ to raise interest rates by 0.25 basis points which led to the unwinding of the JPY carry trade. To unwind this trade, investors sell their assets for USD and then buy JPY to pay down their JPY denominated loans. This causes the JPY to appreciate against the USD adding to the losses of those still in the trade, forcing more selling and further increasing the JPY's value.
So you can see how events like these cause extreme volatility. The question now is, is it over and have we seen the worst? The markets have had a decent bounce and it’s very rare for events like these to have a V shape recovery so most are expecting another leg down. However, the BOJ has already pledged to refrain from hiking interest rates while the markets are unstable.
Flush outs of leverage like this are often healthy for markets, as they help build a more solid foundation for future growth. However, the concern is that the carry trade has not completely unwound. Based on recent economic data, it now seems likely that the U.S. is heading into a recession, which increases the chances of U.S. rate cuts. The problem with U.S. rate cuts is that they put pressure on the USD to devalue against the JPY increasing pressure on a further unwind despite the BOJ’s shifts to a more dovish stance.
So what does the US federal do? Leave rates high, increasing the probability of a deeper, nastier recession. Or cut rates increasing the probability of the rest of the JPY carry trade unwinding.
During times like this, it's important to step back and take a broader perspective. In both scenarios, we can expect volatility, sell-offs, and liquidations, which will likely prompt the Federal Reserve to intervene with monetary support. The Federal Reserve may even preemptively act to mitigate further damage. Ultimately, all paths lead to currency devaluation, driving asset prices higher. They will do whatever it takes to backstop the financial system, and the playbook is clear.
They're becoming more creative and stealth in their methods. For instance, in this scenario, the BOJ bailout will likely occur through a Central Bank Currency Swap (CSWAP) with the U.S. Federal Reserve. To the general public, this seems harmless, but in reality, it's a tool to print infinite amounts of money.
This is explained in ‘‘Spirited Away’’ which is more advanced take and in depth overview on this carry trade by Arthur Hayes (Macro Specialists & Trader) for anyone interested.
This event has solidified my perspective. Previously, I found it difficult to envision a massive injection of liquidity, given that the stock market was at all-time highs and inflation hadn't yet reached the target rate. Now, the reasons for a liquidity injection is evident.
2027 and beyond
A reminder that my bullish view is over next 6 to 18 months. As covered in my Macro Blueprint I’m trying to time the liquidity cycle. In amongst the chaos caused from events like these you can’t help but think, “is this it, is this Ponzi financial system finally coming to an end, is it all collapsing.” All it takes is some simple math calculations on the levels debt to see that this is not sustainable. I think AI and robotics will save us with a productivity miracle. However, I’m well aware that a system collapse as described in the documentary “The Great Taking” is very possible, if not probable.
If I'm correct about the short term (6–18 months), I plan to use the capital I gain to significantly reduce my debt to be prepared for both outcomes. This is something I never thought I'd say, as leverage and debt have been major contributors to my success thus far.
Since this post is topical, I'll leave it here for now, but next time, I'll expand on my strategies and portfolio.
For those who have been looking to deploy some capital into Bitcoin or the crypto markets but finding it difficult given the current environment. I will leave this chart for you here.
