Market Crash! Japan's Stock Market Sees Historic Drop: What Happened?

On August 5th, the global financial markets witnessed a shocking event: Japan's stock market experienced its largest single-day drop in history. The Nikkei Index plummeted by 12.4% in one day, erasing 4,451 points, a drop even more severe than Black Monday in 1987.

In just a few trading days, the cumulative decline reached 26%. This suddenCRAsh not only shook Japan but also triggered a chain reaction in global markets. South Korea and Taiwan's stock markets also plunged by 9%, while major U.S. indices fell by about 3%. So, what exactly caused this financial storm?

The Double-Edged Sword of Yen Carry Trade

To understand the recent plunge in Japan's stock market, one must first comprehend yen carry trade.

For a long time, due to extremely low yen interest rates, global investors borrowed large amounts of yen and converted them into higher-yielding currencies to earn interest rate differentials.

However, this seemingly risk-free arbitrage trade hides significant risks. When the interest rate differential between the yen and the dollar changes, this arbitrage model can quickly collapse. In March of this year, the Bank of Japan implemented its first rate hike in 17 years, ending the negative interest rate policy.

On July 31st, Japan raised rates again, while at the same time, U.S. inflation cooled, leading the market to widely expect the FederalReserveto cut rates in September.

This series of actions directly led to a narrowing of the interest rate differential between the yen and the dollar, undermining the basis for yen carry trades. Investors began to buy large amounts of yen in the foreign exchange market to repay their yen borrowings, causing the yen to surge 12% against the dollar in one month.

The Buffett Effect

In this financial storm, international investors, including Warren Buffett, played a role in exacerbating the situation. During the 2020 pandemic, Buffett began investing in the Japanese stock market, purchasing a series of high-dividend stocks. By 2023, Buffett further increased his investment in the Japanese stock market, sparking a global investor frenzy for Japanese stocks.

In 2023, net purchases by overseas investors in the Japanese stock market exceeded 3 trillion yen, pushing the Nikkei 225 Index up by 28% within a year. By March 2024, the index had broken through the 40,000-point barrier, with an increase of nearly 80%.

Despite Japan's economy not having fully recovered, the Japanese stock market reached new historical highs, driven largely by international investors.

However, as the yen's rate hikes and the anticipated U.S. rate cuts converged at a historical juncture, these international investors began to massively sell off Japanese stocks, triggering a market stampede. In the rapidly declining market, many leveraged investments were forced to liquidate, leading to further accelerated declines and a series of cascading effects. Thus, the historic catastrophe in Japan's stock market was born.

Future Outlook

After the crash, Bank of Japan Deputy Governor Shinichi Uchida quickly stated, "We will not raise rates under unstable financial market conditions." While this statement provided some short-term relief to the market, the long-term expectation of rate hikes by the Bank of Japan seems irreversible.

Meanwhile, the latest data from the U.S. Department of Labor showed a significant drop in initial jobless claims, the largest decline in a year, indicating an improvement in the job market. This data stands in stark contrast to last week's, which had sparked discussions about a potential U.S. recession.

Reflecting on the bond market, this led to a significant dip followed by a rebound to yields above 4%.

However, in the long term, the market's expectation for a Federal Reserve rate cut is becoming stronger. The probability of a 50-basis-point rate cut in September has surged from 22% a week ago to 56.5% recently. Over 70% of the market believes there is a more than 78% chance of a total rate cut exceeding 100 basis points this year.

The trend towards U.S. rate cuts seems inevitable, almost confirming that the boom in Japan's stock market is over. How things will develop next remains to be seen.

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