Surging Yen Amidst Recession Trades Hits Global Stocks
In recent weeks, the global financial landscape has witnessed unprecedented turbulence, culminating in what many have dubbed "Black Friday" on August 2nd. On this day, Japan's Nikkei Index plummeted by 5.8%, a rare occurrence, while other Asia-Pacific and U.S. markets fell by more than 2%. The release of U.S. non-farm payroll data set off alarm bells, with the VIX index—often referred to as the "fear index"—soaring to its highest level in 18 months.
The volatility can be traced back to a confluence of risk factors that have escalated since July. Approximately three weeks prior, the U.S. stock market showed signs of a significant rotation, with major tech stocks experiencing downturns that affected overall index performance. The Japanese Yen also began to rebound, only for the Bank of Japan to surprise the market with an interest rate hike and a gradual reduction of its asset purchases. Over two weeks, the dollar depreciated against the yen by roughly 8%, as the interest rate gap between the two nations narrowed sharply. This led to the unwinding of carry trades where investors had bet on borrowing at lower rates in Japan to invest in higher-yielding assets in the U.S., and subsequent earnings reports from technology giants revealed disappointing results, exacerbating declines in U.S. equity markets. Money flowed back into Japan, driving up the yen's value and precipitating a steep sell-off in Japanese stocks, particularly impacting export-driven sectors.
The blow was compounded when the U.S. non-farm payrolls data released on August 2 indicated an unexpected rise in unemployment to 4.3%, the highest level seen in nearly three years and surpassing the previous figure of 4.1%. This news triggered the Sahm Rule, a predictive measure of economic downturns, which has an alarming accuracy rate of 100% in forecasting recessions. Even predictions of interest rate cuts by the Federal Reserve in September could not soften market fears. Goldman Sachs suggested that if subsequent employment data continued to fall short of expectations, the Fed might implement an emergency rate cut of 50 basis points.
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According to Eric Robertsen, Standard Chartered's Global Chief Strategist, the broad deleveraging of carry trades based on the yen was underway, although the prospect of U.S. rate cuts seemed to alleviate some of the market's risk-averse sentiments. However, with the U.S. presidential election approaching, uncertainty surrounding possible controversies could amplify investor nervousness, overshadowing any benefits from rate cuts. If the current narrative of a "soft landing" globally shifts towards concerns of a "hard landing," then risk premiums might rise further, leading to a significant decline in global interest rates and possibly a resurgence of the dollar.
The aftermath of the unwinding of carry trades has continued to create shockwaves throughout the financial markets. The Bank of Japan, notoriously known for its unexpected moves, announced a 15 basis point rate increase on July 31, far earlier than the consensus view of September or October, and even exceeding the projected 10 basis points. The central bank also laid out plans to gradually cut back on its monthly bond purchases, targeting a reduction to 3 trillion yen by March 2026.
Over the past two years, the Japanese stock market had drawn global investment with its impressive rally, but aggressive actions by the central bank have recently led to a sell-off, with the yen closing at 146.25 against the dollar on August 2—a near 10% gain from its previous historical low.
This financial storm in Japan is not confined to its own markets but has reverberated globally. With the yen's ascent and U.S. Treasury yields declining—from a high of over 5% for 10-year bonds down to about 3.8%—the attractiveness of carry trades has evaporated. Traders who had previously financed their investments in high-yielding markets using inexpensive yen now find themselves facing losses both from the decline in high-yield assets and the yen's appreciation. This alarming reversal has led to a mass liquidation of global carry trades.
James Stanley, a senior strategist at Gain Capital, noted the dramatic drop in carry trade attractiveness, with significant sell-offs occurring in pairings such as Euro/Yen, Pound/Yen, and Aussie/Yen over the past week. He pointed out that as prices continue to fall, long positions held by traders will be more strongly motivated to liquidate to secure gains realized, showcasing signs that carry trades may soon be at an end; failure to act could turn paper profits into losses.
Market volatility has notably intensified as these trades unwind. Currency pairs characterized by high volatility have undergone significant reversals, such as the Mexican Peso's cross rate versus the yen, which has dropped 11% from peaks seen in July.
Apart from the yen's own influences, the ongoing decline in U.S. tech stocks has persisted, while Treasury yields have plummeted amid recession fears. This reality indicates that losses from carry trades could worsen, leading to increasing pressure for liquidation.
On August 2, the Nasdaq 100 index closed at 18,440.85 points, reflecting an almost 11% decline from its earlier historical high of 20,700 points.
The turmoil was starkly exemplified by the disappointing earnings reports from tech giants released after hours last Friday. Intel reported lackluster results and a dismal outlook, announcing a dividend freeze and a 15% workforce reduction, resulting in a 20% drop in its stock price. Amazon's second-quarter revenues and forecast for the third quarter fell short of expectations, leading to a 6% decline in its stock, while Apple saw a marginal 0.6% drop in after-hours trading despite better-than-expected overall performance—driven by strong growth in its services sector which offset a year-over-year decline in iPhone revenues.
The narrative surrounding a "soft landing" for the U.S. economy began to unravel rapidly. Around the same time that market volatility soared, "recession trades" started bubbling to the surface. Analysts began to suggest that the Federal Reserve ought to have cut rates by the end of July instead of waiting until September.
Non-farm payroll data brought "Black Friday" to a climax. The U.S. economy added a mere 114,000 jobs in July, versus an expected 175,000—a data point heralded as one of the weakest since the outbreak of the COVID-19 pandemic. More troubling was the unexpected rise in unemployment to 4.3%, which exceeded economists' expectations of 4.1%, marking the fourth consecutive month of increases.
This environment of dismal job growth stoked fears of a more severe economic downturn, inciting further sell-offs in U.S. equities, thereby pushing down Treasury yields, while demand for gold surged, driving prices to new all-time highs as investors sought safe havens.
Indeed, economic data emerging that week indicated widespread underperformance. On August 1, the ISM manufacturing index reported weakness, ringing alarm bells regarding recession risks. The overall PMI contracted at the fastest pace in eight months, with employment and new orders shrinking even more swiftly. That same day, the yield on 10-year Treasury bonds fell below 4% for the first time since the pandemic.
Chairman Jerome Powell's remarks following an interest rate meeting suggested that if inflation data cooperated, discussions about rate cuts would occur in September, signaling a low bar for easing monetary policy. However, Goldman Sachs expressed concerns that labor market conditions were becoming increasingly contentious, particularly as rising unemployment could signal a more substantial economic slowdown.
Goldman further stated that should August's employment report remain lackluster, a 50 basis point emergency rate cut could happen during the September meeting. The bank currently anticipates a terminal rate between 3.25% and 3.5%, while projecting increments of 25 basis points cuts every other meeting in 2025 and 2026, partly due to increased uncertainty surrounding economic policy post-election.
Notably, the inversion of the U.S. Treasury yield curve has persisted for nearly 42 months—surpassing the duration observed during the Great Depression of the 1930s—yet previously, few had considered this a genuine indicator of impending recession.
Now, however, the Sahm Rule has been triggered, amplifying recession fears. The pressing question remains whether the Federal Reserve is falling behind the curve, as indicators of ongoing labor market weaknesses continue to mount. In July, the Fed estimated a 55.8% probability of recession, while last week's fluctuations in government bonds added to the existing inversion of the yield curve.
As the situation evolves, Asian stock markets have also begun grappling with increased volatility. Currently, the currency markets appear to be pricing in a 200 basis point rate cut by the Federal Reserve before the end of 2025. This situation raises the question: Is this a cause for celebration or concern for Asia's stock markets?
Goldman's latest research indicates that historically, Asian stock markets tend to perform well following the Fed's initial rate cut; however, in an environment of recession, such performance may be stunted. Various sectors respond differently under differing macro conditions, with healthcare and consumer sectors favorably impacted following the first cut, while defensive stocks and commodity sectors tend to outperform cyclical and financial sectors in recession scenarios.
During the week of July 29 to August 2, the MSCI Asia Ex-Japan Index (MXAPJ) fell by 0.8%, dragged down primarily by declines in the Philippines, Taiwan, and South Korea (each down 2%), while Thailand, Australia, and Indonesia fared better than the overall market.
In terms of the foreign exchange landscape, Asian currencies largely appreciated against the dollar. However, the question of whether the strong dollar has reached its peak remains highly uncertain.
The dollar index dipped by 0.1% in July, with the yen leading the charge in strength, a robust movement that has spilled over into other Asian currencies. According to Robertson, in July, the Malaysian Ringgit and Thai Baht followed the yen's lead with significant gains, while the Renminbi, Singapore Dollar, Indonesian Rupiah, and Korean Won rebounded from recent lows. On August 2, the offshore yuan surged nearly 700 points against the dollar, closing at 7.1657.
Simultaneously, Standard Chartered noted that polling indicates a narrowing gap between presidential candidates Kamala Harris and Donald Trump, leading markets to reduce the perceived likelihood of a Trump victory. This shift ought to alleviate geopolitical risk premiums, easing pressures on certain national currencies, particularly the Malaysian Ringgit, Thai Baht, and Korean Won, which are among the most vulnerable.
Robertsen acknowledged the considerable rebound of the Renminbi, although its gains have not matched those of other Asian counterparts. "We expect China will put greater emphasis on stabilizing economic growth and may further cut interest rates, maintaining a spread between U.S. and Chinese rates," he commented.