Markets across the globe experienced chaos on Monday with some suggesting that this was caused by the strategy of carry trades.
On Monday, stock markets across Asia plunged following the release of weaker-than-expected U.S. jobs data on Friday, which had a knock-on effect on the global economic outlook.
Japan's Nikkei 225 index dropped by 13% at its lowest, which was its biggest single-day rout since "Black Monday" in October 1987. This sell-off wiped out the Nikkei 225's gains for the year.
A report from last week showed that the U.S. economy added 114,000 jobs in June, which was far fewer than expected and the U.S. jobless rate also climbed to its highest level since October 2021.
The steep declines were exacerbated in part, by a mass sell-off of U.S. dollars tied to carry trade deals that had previously propelled the markets to record highs.
Carry trades relate borrowing at low interest rates in one currency to invest in higher-yield assets in another currency.
"A carry trade is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency. Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate," Investopedia states.
Recently, investors have borrowed Japanese yen, anticipating that the yen would stay inexpensive compared to the U.S. dollar and that Japan's interest rates would remain low. The borrowed yen is then invested in U.S. stocks and Treasury bonds, with the expectation of earning a higher return.
The main driver of a carry trade is the disparity in interest rates between countries. The Bank of Japan, aiming to stimulate economic growth through increased spending, has maintained near-zero interest rates for years.
Last week, however, it raised its primary interest rate from nearly zero. This hike typically strengthens a country's currency, leading to a surge in the Japanese yen against the U.S. dollar. As a result, some traders moved to offload higher-risk assets to respond with the sudden increase in borrowing costs and declining share values.
The interest rate gap between Japan, now at 0.25%, and the Federal Reserve's benchmark rate of 5%-5.25% remains significant but is expected to narrow as the Fed lowers rates and Japan increases its rates. Financial markets showed signs of stabilizing on Tuesday, with Japan's Nikkei 225 index rising 10.2% and other markets mostly higher.
On Monday, Kit Juckes, Societe Generale's chief foreign exchange strategist published a note on his current research which said, "You can't unwind the biggest carry trade the world has ever seen without breaking a few heads. That is the impression markets give us this morning," CNBC news reported.
In addition to issues relating to carry trades, global fears have been growing because of concerns that include ongoing tensions in the Middle East and several weak earnings reports from major technology firms last week amid increasing investor doubts about the returns from AI investments.
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