Recently, global capital markets have been swept up in sharp volatility, with stock and exchange rate markets going through roller-coaster rides. On August 5, the Japanese stock market fell. The Nikkei 225 index plunged 12.4%, triggering circuit breakers twice during the session and wiping out all gains made earlier this year. The Korea Composite Stock Price Index (KOSPI) fell by 8.8% and triggered the circuit breaker mechanism. Meanwhile, the three major US stock indices also declined, though they were contained in a narrower range of 2-3%. But the next day, global stock markets rebounded strongly. The Nikkei 225 index surged by 10.2%, KOSPI rose by 3.3%, and all three major US stock indices saw an upswing.

 

The significant turbulence in global stock markets, as exemplified by the Japanese stock market, can be attributed to two main reasons:

 

The first reason is the recent strong appreciation of the Japanese yen. The exchange rate surged from 162 yen per US dollar in early July to 141 yen per US dollar in early August, reaching its highest level in nearly seven months. Behind the yen's appreciation lies the Bank of Japan’s unexpected interest rate hike, which caused a reversal in carry trades. Another reason is the risk of a hard landing for the US economy, fueled by slowing economic data in July and rising expectations of Fed rate cuts. The marked weakening of the US employment situation has heightened expectations for a Fed rate cut by 50 basis points in September. This has prompted investors to sell off the US dollar, causing the US dollar index to fall from 105 to 102 within a week.

 

The "carry trade" is a trading strategy wherein an investor borrows in a currency with low interest rates, and reinvests the proceeds in a currency with a higher interest rate or rate of return. Due to Japan's long-standing policy of maintaining zero or even negative interest rates, numerous investors borrow yen at low interest rates, convert it into currencies with higher interest rates like the US dollar, and invest in US stocks and US bonds, or directly purchase Japanese stocks. On July 11, both the Nasdaq Composite and the Nikkei 225 index peaked, while the yen exchange rate began to rebound, indicating signs of a yen reversal.

 

With the slowdown in US economic data, the Bank of Japan's interest rate hike and intervention in the foreign exchange market, the income of the "asset side" of the yen carry trade (US stocks, Japanese stocks, etc.) has declined rapidly, and the cost of the "liability side" (yen) has risen significantly. This reversal in yen carry trades was notably reflected on August 5. The massive unwinding of carry trades triggered a drop in global stock markets, an appreciation in the yen exchange rate, and the creation of a self-reinforcing cycle that escalated into a panic-driven asset sell-off.

 

It is noteworthy that the Japanese stock market and the yen exchange rate typically exhibit a negative correlation. This can be attributed to two main reasons. Firstly, a significant portion of Japanese listed companies’ revenue comes from overseas. Yen depreciation benefits exports and boosts corporate profits, which in turn leads to higher stock prices. Conversely, yen appreciation tends to coincide with a drop in the Japanese stock market. Secondly, the yen is often used as a financing currency by global investors due to its low interest rates and ease of financing. Once the yen appreciates, investors are forced to sell risk assets and buy back the yen, which has a negative impact on capital markets.

 

The yen’s recent rebound is a correction to its previous excessive depreciation, but the room for further appreciation is limited. Despite a slowdown in Japan's economic growth this year, its fundamentals do not support the yen exchange rate falling below 160 to a new low since 1987. In my view, the sharp rebound of the yen since mid-July is a reasonable correction to its previous excessive depreciation. This rebound incorporates factors favorable to the yen, such as the narrowing interest rate differential between Japan and the US, the increased market volatility, and a reversal in carry trades.

 

The second reason is the unexpected rapid slowdown in the US economy, raising concerns about a hard landing. Since August, the US labor market has shown signs of cooling, consumer spending has started to decline, high interest rates have dampened housing demand, manufacturing activity has contracted, and core inflation has moderated significantly.

 

Firstly, new job creation slowed significantly, and the unemployment rate ticked higher. In July, the US economy generated 114,000 nonfarm jobs, behind the revised June figure of 179,000. Wage growth also experienced a notable slowdown, with average hourly earnings increasing by 3.6% year-over-year, down from 3.9% in June. The unemployment rate in July rose to 4.3%. Notably, the US unemployment rate has increased by 0.6% from its lowest point this year and triggered the "Sahm Rule", a recession indicator based on the unemployment rate.

 

Secondly, consumer spending has consistently weakened, accompanied by a decline in consumer confidence. June saw a 0.1% month-over-month decline in retail sales, reflecting mounting pressure on consumer spending. The primary factors driving this decline were spending on automobiles and gasoline, which dropped by 2.3% and 3% month-over-month, respectively. Uncertainty surrounding the elections has also dampened economic prospects, leading to a decline in the US Consumer Sentiment Index. The University of Michigan Consumer Sentiment Index recorded a final reading of 66.4 in July, the lowest level since last November.

 

Thirdly, the real estate market is experiencing weak sales. The 30-year mortgage rate in the US has consistently hovered around 6.7%, the highest level in nearly two decades. US mortgage rates have doubled since early 2022. The high interest rates have forced ordinary people to postpone their first home purchases and upgrade needs. The second-hand housing market is experiencing a supply shortage, resulting in a scenario where transaction volumes decline while prices increase.

 

Lastly, manufacturing activity has consistently contracted. Core capital goods orders in the manufacturing sector have nearly flatlined, showing a mere 0.9% year-over-year growth rate from January to June this year. The latest data from the Institute for Supply Management (ISM) reveals that the US manufacturing Purchasing Managers' Index (PMI) has declined to 46.8 in July, marking the lowest reading in eight months, down from 48.5 in June.

The impact of the economic slowdown is also evident in the continued cooling of inflation. In June, the US CPI fell by 0.1% month-over-month, marking the first month-over-month decline since May 2020. The year-over-year CPI and core CPI dropped to 3.0% and 3.3%, respectively, both below expectations. A general slowdown is observed across various categories. Notably, month-over-month rental growth tapered off to 0.2%, marking the end of a four-month streak of increases exceeding 0.4%.

 

At the July policy meeting, Federal Reserve Chair Jerome Powell affirmed progress in curbing inflation and suggested that the Fed might announce a rate cut at the September meeting.

 

According to the latest data, the US economy remains resilient, making a short-term recession unlikely. Moreover, the Bank of Japan has sought to reassure markets by signaling that interest rate hikes will not be overly aggressive. These two factors have alleviated some concerns, contributing to the recent depreciation of the yen and the rise in global stock markets.

 

The author is the Chief Economist of JD. COM