The Panic Room

A Perfect Storm of Factors

The most cited reason for the market turmoil is the unwinding of carry trades by international investors, who, for years, have been borrowing cheap yen to invest in riskier assets like US stocks. However, things changed when the Bank of Japan started intervening in the currency markets, and the unexpected decision to raise interest rates last week sent shockwaves through the financial markets.

The rate hike caused the Japanese stock market, as represented by the Nikkei 225 index, to swing from an 18% year-to-date gain to a 5% loss. Japanese exporters, such as Toyota, were hit hard by the rising yen and higher interest rates, with their stock prices plunging nearly 25% in a week and almost 35% in a month. If these Japanese stocks were used as collateral for the carry trades, the pressure to liquidate would have been immense. Panic ensued as the Japanese market went into a tailspin, plunging 12% in a day, the worst drop since the 1987 Black Monday crash.

The selling contagion quickly spread to the US stock market, causing the VIX volatility index, often referred to as the “fear index,” to spike to levels not seen since the 2008 global financial crisis and the Covid-19 pandemic. At one point, the VIX surged 180% from its previous close. The S&P 500 and Nasdaq indices fell more than 3%, but what was notable was the surge in trading volume, with nearly 5 billion shares changing hands during the day.

While the Bank of Japan’s rate hike was a significant trigger, there were other factors at play that contributed to the panic and selling frenzy.

Firstly, the sharp drop in US government bond yields signaled an anticipated easing of monetary policy as economic data started to show signs of weakness, including slower growth and rising unemployment. Interestingly, the latest employment report confirmed this trend, with the Sahm Recession Indicator flashing a warning sign of a potential recession.

Secondly, the market’s prediction of a rising probability of a US recession within the next year, coupled with legendary investor Warren Buffett’s sale of Apple stock and his accumulation of nearly $300 billion in cash, sent a strong signal that the market may be overvalued. When Buffett’s Berkshire Hathaway refrains from investing or reduces its equity exposure, it often indicates that stock valuations are stretched.

Thirdly, investor expectations for the US economy and the stock prices of tech giants were exceptionally high, and many of these investments were likely leveraged. When investors who had reached their profit targets began to sell, it put pressure on those who had used margin to amplify their bets.

Lastly, geopolitical risks, such as the Israel-Iran conflict, added to the anxiety among investors, and the contagion effect could have been amplified. Typically, safe-haven assets like gold and oil benefit from stock market declines, but this time, they too suffered losses, possibly due to panic selling or margin calls across different asset classes.

While the unwinding of carry trades was likely the primary catalyst, the aforementioned factors each played a significant role in the market turmoil. However, it is challenging to quantify the exact impact of each factor as they occurred in close succession.

Better Safe Than Sorry

Despite the panic and selling, the US stock market closed well above the levels seen during the Black Monday crash of October 19, 1987, when the S&P 500 index fell 20% and the Nasdaq dropped 11.5%. During the Covid-19 crisis, the S&P 500 and Nasdaq indices both fell by around 12%. Additionally, the S&P 500 has yet to enter correction territory, defined as a 10% decline from its recent peak.

Nevertheless, the market turmoil serves as a stark reminder of the risks associated with leveraged investing, and both lenders and borrowers should reassess their risk exposure and collateral requirements to prevent a repeat of incidents like the collapse of Credit Suisse, which suffered significant losses due to its exposure to the highly leveraged Archegos Capital in March 2021.

Moreover, a Fed rate cut in response to signs of a recession is not always positive for the stock market. History has shown that rate cuts in 2001 and 2007 preceded prolonged bear markets in US stocks. There is also criticism that the Fed is behind the curve in responding to economic developments, having been slow to raise rates to combat inflation and now potentially being late in cutting rates as the economy weakens.

The stock market is a prime example of “random walk” dynamics in the short term, influenced not only by fundamental factors of businesses and the economy but also by the psychology of market participants. The recent sharp rise (largely driven by FOMO—fear of missing out) and subsequent correction are natural and healthy as they bring stock prices back in line with the underlying value of the businesses in the long term.

To guard against future market crashes, the role of regulatory bodies becomes crucial. They should be proactive, vigilant, and closely monitor periods of heightened risk-taking, especially in speculative investments fueled by financial leverage. Additionally, fostering information exchange, risk management methods, and tools among market participants is essential to mitigate the contagion effect of market instability.