This week, global markets experienced a rollercoaster ride, sparked by last Friday’s increase in the U.S. unemployment rate to 4.3%, which triggered the Sahm Rule and led to significant turbulence in global financial markets. Signs of this volatility were already evident from Thursday to Friday of last week. In our previous report, we had noted that the rapid decline in the Japanese stock market might put pressure on the Bank of Japan (BoJ) to adjust its interest rate policy. On Monday, Japanese stocks hit multiple circuit breakers, eventually closing down by 10%. Major global investment banks quickly issued their assessments, with a consensus that the market’s decline was largely driven by carry trade unwinding. They recommended closely monitoring short positions in Japanese stocks as a key indicator of market stabilization. We will not delve into the specifics of carry trades here.
However, it is worth noting two key points. First, the impact of carry trades on the Japanese stock market has occurred multiple times in history, often during BoJ interest rate hikes. On July 31, the BoJ announced a 25 basis point rate hike and reduced asset purchases, leading to a three-day decline in Japanese stocks starting on Wednesday. This was largely expected by the BoJ. As Japan’s CPI gradually strengthens, the urgency for normalizing monetary policy exists but is not overwhelming. The Nikkei index had already fallen by 10% from Wednesday to Friday, exacerbating market panic. The situation was further compounded by last Friday’s sharp rise in the U.S. unemployment rate, triggering the Sahm Rule and fueling expectations of accelerated Fed rate cuts. This, in turn, led to the unwinding of yen short positions in carry trades, sparking a significant market storm on Monday.
Our first reference point is that the carry trade unwinding triggered by yen rate hikes was foreseeable. Secondly, the combined effect of carry trades and U.S. rate cut expectations caused significant market volatility, highlighting the strong impact of international monetary policy coordination. This also explains why the BoJ has been reluctant to accelerate its monetary normalization plan. Following this incident, the pace of Japan’s monetary normalization is likely to slow further.
There is a classic saying in carry trading: “Exchange rates go up by stairs and down by elevator.” For investors, the sentiment impact of this yen carry trade on the Chinese stock market is likely to grow. Japan’s path to normalization will have several critical junctures worth monitoring. Each yen rate hike could trigger a pullback in global stock and capital markets. Although Japan is not a major global currency, it still has a certain impact on global stock market liquidity due to the leveraged nature of carry trades, where unwinding can occur rapidly.
Following the sharp decline in Japanese stocks on Monday, the BoJ, Ministry of Finance, and key government leaders quickly intervened to calm market sentiment. The market rebounded from Tuesday, recovering most of the losses from last Friday and Monday. The BoJ’s deputy governor stated in a press conference that the BoJ would not raise rates during periods of market instability, which significantly eased concerns among global traders.
The U.S. also released an interview on Tuesday with a researcher of the Sahm Rule, a former Federal Reserve official. She highlighted two crucial points:
1) The U.S. labor market has undergone significant changes, with the Sahm Rule being triggered more by an increase in labor supply than by a decrease in demand. Thus, a U.S. recession is not the standard expected scenario.
2) The original intent behind the Sahm Rule was to serve as an early warning to prompt fiscal policy action.
It is evident from his remarks that, as a former Fed official, her views align closely with the current Fed’s stance. The Fed’s assessment of the U.S. economy is based on a broad range of data, not just a single indicator. Her comments seem to avoid criticizing the current Fed, which could interfere with its policy actions. This week, several Fed officials also spoke out to reassure the market. While there is ongoing debate about whether the U.S. economy will achieve a soft landing, it is clear that next week’s U.S. CPI data will be a critical indicator. If the CPI unexpectedly declines, it could ease market anxiety and reignite rate cut expectations. Last week, we identified commodities and bonds as promising investment directions. Since last Friday, commodities, U.S. Treasuries, Japanese government bonds, and European bonds have all undergone significant adjustments, leaving few opportunities for returns next week. Participating in trades around the U.S. CPI release might be a better strategy.