August Market Review

August ended on a positive note after a stumble at the beginning of the month, which I will explain below.
• S&P500: +2.28%
• Nasdaq: +1.10%
• Stoxx Europe: +1.33%
• All Country World Index EUR: +0.24%
• Global Fixed Income Index EUR: +0.07%

It is often thought that August is a calm month because everyone is on vacation, but in financial markets, it has become one of the most volatile months of the year. This is because, with fewer investors working, there is less liquidity, making the markets more sensitive to unusual news.

On August 5th, when I woke up and started reading the news, I was startled to see Japan’s Nikkei stock index drop 12%, dragging the rest of the Asian markets down with it. The U.S. had also closed with significant declines. But what happened?

As I mentioned earlier, August movements are amplified by out-of-the-ordinary news. Is it truly out-of-the-ordinary, or is it something we could have expected? I believe it’s more predictable than we’re led to think, but we don’t know when it will happen.
Wait, are you saying you knew, and you did nothing to avoid losses that day? No, not at all. Let me explain, and then I’ll take the criticism, just like the saying goes: economists get paid twice—once for making predictions and again for explaining why what was predicted didn’t happen.

What happened?
The cause of the drop was the unwinding of the Japanese “carry trade.” Alright, but what is that? I’ll start with a past reference that will help explain it. Many of you may remember foreign currency mortgages from a few years ago. I recall a friend being offered a mortgage in yen because “it was cheaper.” It was cheaper because interest rates in Japan were close to zero, while euro rates were higher. So, the loan was taken in yen at a 0% interest rate, and voilà, magic done. What could go wrong? Well, in economics, every action has its consequences, as I’ve mentioned before. As long as the yen stays the same or falls against the euro (for a European), there’s no problem. But what happens if it rises? The loan becomes more expensive because you’ll need more euros to exchange for yen to repay it.

Essentially, this is the “carry trade”: borrowing in a low-interest-rate currency and investing that money in other financial assets with potential for appreciation. As you can see in this chart, the growth of loans in yen to foreigners increased by $1 trillion (145 trillion yen) between 2007 and 2024.

Source: Charles Schwab, Bank for International Settlements

The most common carry trade involves borrowing in yen and investing in U.S. Treasury bonds with higher rates. The profit comes from the interest rate differential between the U.S. and Japan. But is the profit always positive? Not always, as there are three possible scenarios:

1. The yen falls. You gain the differential plus the dollar’s appreciation against the yen. Congratulations!
2. The yen stays the same. You gain the differential. Well done!
3. The yen rises. If the yen rises against the dollar above the differential, losses begin from an apparently prudent operation, and these losses can be significant.

But it wasn’t just U.S. Treasury bonds that were bought; a lot of equity was purchased, banking on the U.S. economic recovery, improved corporate results, especially those linked to artificial intelligence, and the belief that the yen would remain stable or even fall. This latter hypothesis was based on Japan’s primarily export-driven economy, which would lead the Bank of Japan (BoJ) to favor a weaker yen.

There’s another ingredient in this mix: in October 2010, the BoJ decided to buy several financial assets to stimulate Japan’s struggling economy. What surprised the investment community the most about this strategy was the inclusion of equity ETFs, essentially buying stakes in Japanese companies. Today, with an investment of $470 billion, the BoJ has become one of the largest shareholders in Japanese companies, thus influencing market dynamics. The massive money printing to buy these assets has been a tactic to generate inflation after decades of near-zero inflation.

What could go wrong with this carry trade strategy?
The yen rising—and that’s what happened. From mid-July to August 5th, the yen appreciated by 12%, a significant movement for currencies.
Why did the yen rise? Primarily to prevent runaway inflation. Let me explain:

1. After several years of low inflation or even deflation, significant liquidity injection programs (money printing), and the end of the pandemic, inflation surged, exceeding 4% in 2023. This level is not alarming but dangerous if the volume of liquidity in the system is high.
2. The BoJ, after decades of zero or negative rates, started raising rates this year—0.25% in March and another 0.25% in July.
3. The yen hit its lowest levels against the dollar in mid-July, and the BoJ injected 50 billion yen to support the currency (selling dollars and buying yen).

The straw that broke the camel’s back was a poor U.S. employment report on Friday, August 2nd, just before “Black Monday.” This led to expectations of a more significant rate cut at the next Federal Reserve meeting and accelerated the yen’s rise, which had been appreciating since mid-July. Why? Because if the Fed lowers rates and the BoJ raises them, it encourages the sale of dollars and the purchase of yen, as it becomes more profitable to invest in Japanese bonds.

On Monday, August 5th, Japan’s market fell 12%, and the so-called “margin calls” began. That is, lenders who had loaned in yen started demanding repayments as debt limits were breached both from the debt side (the yen was rising) and from the collateral side (the stocks, which serve as loan collateral, were falling).

Source: Bloomberg

This chart shows the correlation between the Nasdaq (the U.S. technology index in blue) and the yen (green line). The yen’s rise coincides with the Nasdaq’s decline, meaning investments in Nasdaq were being sold to buy yen and repay loans (unwinding the carry trade).

And why did Japan fall so much?
Remember that one of the largest buyers of Japanese stocks was the BoJ. Moreover, the BoJ telegraphed its equity buying strategy, so many investors borrowed in yen to buy Japanese stocks and take advantage of the potential rise.
However, once the margin calls were triggered, there was no choice but to sell. Given the massive size of the carry trade investment, the magnitude of the fall becomes more understandable.

After statements from the BoJ calming investors by saying they were suspending future rate hikes and somewhat reassuring U.S. employment data, global equity indices quickly recovered. Thanks to this, August ended positively.

To conclude, two final points:

1. Is it over? From what I’ve read from several analysts, about 50-60% of the global carry trade has been unwound. So, there’s still some way to go. We don’t know whether this will be completed immediately or not—it will depend on the yen’s movement. The BoJ can manipulate the yen, but only in the short term. And as financial market history has taught us, political decisions aimed at short-term solutions can have unintended long-term consequences.
Moreover, if the U.S. starts a trend of rate cuts, it will put upward pressure on the yen, as it incentivizes the return of capital invested in the U.S. back to Japan through the sale of dollars and the purchase of yen.

2. I mentioned at the beginning that these were unusual events, and I asked, “why?” I recall that before the U.S. mortgage crisis in 2009, someone said that despite the risks being taken, the game of musical chairs had to continue until the “music stopped.” That is, many knew about the risks being taken, but no one wanted to be the “fool” who exited first.
To step out of the crowd, it’s essential to analyze what’s happening thoroughly. If you believe something doesn’t “smell right,” it’s best to refrain from investing there, regardless of the prevailing consensus. You might be seen as a “fool” for not investing in certain trendy areas, but as Warren Buffet said, “only when the tide goes out do you discover who’s been swimming naked.