Executive Summary
To take advantage of negative interest rates in Japan and a strengthening dollar, investors have been borrowing funds in yen and investing in the U.S. and abroad. This “carry trade” allowed investors to achieve a higher yield on their investments and possibly gain on the weakening yen. However, this seemed to come to an abrupt halt with the July increase in Japan’s discount rate. The dollar/yen ratio dropped from 162 yen/dollar to 144 as of Monday of this week, sparking some to sell stocks. A combination of unwinding the carry trade, weakening U.S. and global economies, and geo-political tensions has put fear in the eyes of investors. Recently the S&P has sold off around 9%.
Please proceed to read The Details below for more information.
“The typical experience of the speculator is one of temporary profit and ultimate loss.”
–Benjamin Graham
The Details
The discount rate in Japan was lowered from 0% to -0.10% in January 2016. The discount rate remained negative until March of this year, when it was raised to 0.10%. In July it was raised again to 0.25%. The Federal Reserve started to raise the U.S. Federal Funds Rate from the zero bound around March of 2022, until peaking at the current rate over 5%. The rising Fed Funds Rate pushed the dollar up relative to the yen. (See graph below)
To take advantage of the negative interest rates in Japan and strengthening dollar, investors began borrowing funds in yen and investing in the U.S. and abroad. This “carry trade” allowed investors to achieve a higher yield on their investments and possibly gain on the weakening yen.
This seemed to come to an abrupt halt with the July increase in Japan’s discount rate. The dollar/yen ratio dropped from 162 yen/dollar to 144 as of Monday of this week. This drastic drop forced many investors to begin to unwind their carry trades. This meant selling investments such as U.S. stocks. Additionally, Japan’s Nikkei 225 Index which crashed in late 1989/early 1990, finally this year surpassed the 1989 peak. However, on Monday of this week, the Nikkei 225 fell over 12% putting it back below its peak of almost 35 years ago.
A combination of unwinding the carry trade, weakening U.S. and global economies, and geo-political tensions has put fear in the eyes of investors, and has led to a roughly 9% selloff in the S&P 500. With stocks remaining significantly overvalued, it seems ludicrous that many investors are already hoping for the Fed to come to the rescue. Calls for rate cuts of up to 0.75% were spreading Monday hoping to prevent the unwinding of the “everything” bubble.
What many investors seem to be forgetting is that historically, when the Fed dropped rates at this point in the cycle, stocks did not rise, but instead dropped further…sometimes much further! It seems the unwinding of the carry trade was part of the spark for the current selloff. Will this continue as a full blown correction? Only time will tell. Stay tuned for more updates.
The S&P 500 Index closed at 5,347, down 2.1% for the week. The yield on the 10-year Treasury Note fell to 3.79%. Oil prices decreased to $74 per barrel, and the national average price of gasoline according to AAA fell to $3.47 per gallon.
© 2023. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.
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