Nikkei Plummets 10,000 Points, Fed May "Hard Land"
The recent downturns in major global stock markets, particularly the significant plummet of both the U.S. and Japanese stock exchanges, have reverberated throughout the Asia-Pacific region, leading to widespread financial anxiety. As of August 5th, the Nikkei 225 index suffered a staggering loss of over 13%, settling at approximately 31,078 points after hitting a circuit breaker due to the severe decline. This came on the heels of a nearly 5.8% drop the previous Friday, illustrating an alarming trend in market volatility.
With this shift, the Nikkei 225 has fallen back to levels last seen in September 2023, shedding over 10,000 points from its highest peak of the year where it reached 42,426.77 points. Despite a nearly 20% overall increase since the beginning of 2023, largely due to Japan's ongoing governmental reforms welcomed by international investors, the current atmosphere is starkly different. Data from the Tokyo Stock Exchange reveals that net foreign capital inflow into Japanese stocks has surged to approximately 6.3 trillion yen ($43.9 billion) in 2023, marking the highest level since 2014.
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However, this infusion of foreign investment has recently been upended. Just last week, the Bank of Japan (BOJ) shocked global markets with a hawkish shift in its monetary policy which resulted in the Japanese yen appreciating significantly against the U.S. dollar – by nearly 14% in July alone. This drastic currency shift has devastated Japanese equities, particularly for large export-oriented firms. On the other hand, the broader implications of the U.S. tech sector's downturn have accelerated this market liquidation, illustrated by a more than 10% drop in the Nasdaq 100 index.
The implications of this market instability are palpable. Unusual discounting of cross-border ETFs trading both American and Japanese stocks emerged: while these financial instruments typically reflect a premium of 2% to 5%, they encountered rare discounts nearing 2%. However, currencies such as the Chinese yuan and other low-yield Asian currencies saw remarkable rebounds, reflecting the wider market adjustments, with the yuan gaining nearly 1,500 points since July.
Insights from various financial institutions indicate that the Asian markets can rarely stand apart from the turmoil of their Western counterparts. Reports suggest a continued outflow from A-shares, hinting that, should the anticipated American economic downturn unfold, it would negatively impact Asian markets even if an interest rate cut occurs. Veteran macro trader Yuan Yuwei explained, “We are bearish across all three major markets: U.S., Japan, and Europe. With Japan's market being a long position, we liquidated our holdings two weeks ago. The current situation of plummeting equity markets mirrors the unprecedented ‘black swan’ events witnessed in A-share micro-cap stocks earlier this year, signifying systemic risks embedded in these financial markets, uncorrelated with macroeconomic conditions." He does not foresee substantial impact from foreign market drops on domestic stocks, except in terms of market sentiment.
As the waves of global market tumult continue, particularly characterized by last week’s “Black Friday” on August 2nd, the fluctuations have magnified the losses across markets. On that day, the Nikkei index fell by a striking 5.8%, leading to similar declines of over 2% in key Asia-Pacific and U.S. stock indices. Following the release of the U.S. non-farm payroll data, the VIX, a barometer of market volatility, surged to an 18-month high. Yet, the dive did not cease there; the following Monday witnessed even deeper losses in the Asia-Pacific stock markets, indicating an ongoing bearish sentiment.
In the past few weeks, numerous risk factors have converged. The U.S. stocks entered a phase of rotation, causing a decline in major tech companies and subsequently affecting broader indices. Meanwhile, the rising yen triggered by an unexpected interest rate hike and balance sheet tightening by the BOJ—including a notable rate hike of 15 basis points (bps)—further compounded the volatility as the dollar depreciated against the yen by approximately 8% within two weeks. Following disappointing earnings reports from giants of the tech sector, the resulting capital reallocation exacerbated the downturn, resulting in further losses in Japanese equities.
The ripple effects are immense, particularly as the flow of investments returns to Japan, further fortifying the yen and intensifying stocks’ declines. Such turbulence in the markets is increasingly alarming as recent U.S. labor data on August 2 showed an unexpected rise in unemployment rates to a near three-year high of 4.3%, triggering predictions of impending recession through the “Sahm Rule,” which is known for its precise recession predictions. Consequently, market anxieties have heightened, prompting discussions of possible emergency rate cuts by the Federal Reserve even before their anticipated meeting in September.
The rising yen is among the primary catalysts for these developments; however, changes within the American market undoubtedly exacerbate the scenario. This discussions hark back to a major rotation in the U.S. stock market three weeks ago, where worries about tariffs impacting tech stocks shifted investor interests towards smaller companies sensitive to interest rates, leading to a sharp uptick in volatility. Over five days concluding July 19, the Russell 2000 index experienced a remarkable 9% increase, while the S&P 500 index registered a decline, amplifying a 10% gap—a rare occurrence in four decades.
The consistent downtrend of heavyweight tech stocks has adversely affected the overall U.S. stock market. As of the recent market close, the S&P 500 index retreated from over 5,600 points to around 5,500, with the Nasdaq 100 sliding from approximately 20,700 points to approximately 18,440. Concurrently, U.S. Treasury yields have plummeted, with consequently a flight of capital into the bond market for safety, where the ten-year yield fell from 4.2% to about 3.7%.
Moreover, Japan’s committee at the BOJ announced its intention to progressively reduce its purchase of Japanese government bonds while simultaneously hiking interest rates. Projections suggest that by March 2026, the monthly bond purchasing targets will decrease to 3 trillion yen. As this financial landscape shifted dramatically—where the rapid appreciation of the yen contrasted starkly with the decline in the dollar—the fallout manifested as an extensive liquidation across yield arbitrage trades.
To illustrate this scenario, traders previously capitalized on low interest rate yen financing to invest in higher-yield markets, such as U.S. assets, benefiting from both currency appreciation and asset value growth. With the interest rate differential previously near 5% and the yen weakening by over 10% earlier this year, the current yield spread has tightened to 3%. Simultaneously, due to the yen’s unprecedented surge of 14%, significant losses were incurred in dollar assets, contributing to the unwinding of such trades, propelling a tsunami of capital back to Japan—further driving the yen's strength.
This twist of fate heralded a nightmare for the Japanese stock market. An investment management executive remarked that Japan's previously solid market performance was directly tied to the BOJ's sustained monetary easing—which depreciated the yen, significantly enhancing Japan's export competitiveness and bolstering the tourism and service sectors. However, the transformation towards a strengthening yen poses a formidable challenge for the continuation of this growth trajectory.
The overarching uncertainties are projected to persist. While the Japanese market presents a picture of instability, the challenges within the American market further amplify concerns. Analysts suggest that the so-called “super central bank week” may have concluded, yet market turbulence might not abate anytime soon. Jerry Chen, a senior analyst with a global financial advisory firm, underscores this sentiment, indicating that “the emergence of recession trade is poised to take precedence over the previously prevailing rate cut trade. This week invites scrutiny towards economic data from China and the U.S., along with the decisions from the Reserve Bank of Australia on interest rates."
The dismaying U.S. non-farm payroll data showed a mere increase of 114,000 jobs, marking a year-to-date low, while the prior month’s figures were revised downward to 175,000. This report revealed an unexpected uptick in the unemployment rate to 4.3%—the highest it has been since October 2021—and a drop in hourly wages growth to a 3.6% year-on-year increase, all underperforming expectations. This data triggered the influential Sahm Rule, which flags high probabilities of recession, fanning anxieties within the markets. Investment banks, including Goldman Sachs, projected that should subsequent employment reports continue to fall short, the Federal Reserve may opt for an emergency cut of 50 basis points by September.
The anticipation of an emergency rate drop by the Fed has gained traction among market participants, with current betting suggesting a 60% probability of a 25 basis point cut within a week. Meanwhile, recent disappointing earnings reports from tech titans have accelerated sell-offs, particularly in the technology sector, as evidenced by Intel’s staggering 26% drop last Friday. Over the past four weeks, the Nasdaq and S&P 500 indices each experienced declines from their historical highs, with the Nasdaq entering a technical correction phase as it accumulated a 10% drop.
Adding to the concerns, media reports indicated that investment mogul Warren Buffett’s Berkshire Hathaway reduced its Apple shareholdings by nearly 50% during the second quarter, further aggravating market bereavement. Despite Apple’s robust market value of $3.3 trillion, which holds the top spot among U.S. equities, Buffett's decisions have evoked worries about worsening market conditions.
In sharp contrast, the yuan has dramatically benefited from this turbulent period. As of August 5th, the USD/CNY traded at 7.1442, while the offshore yuan traded at 7.1357, reinforcing the dollar's earlier decline below 7.3. Traders speculate that the spike in the yen due to the unwind of carry trades urges the yuan to appreciate, a trend propelled further as the dollar index faced significant breaches. Recently, certain exporters have impulsively started converting their dollar earnings into yuan, which may exert additional upward pressure on the yuan.
However, China's stock market continues to exhibit symptoms of external emotive influences. On the same day, China’s Shanghai Composite Index closed down by 1.54%, resting at 2,860.7 points, while Hong Kong’s Hang Seng Index fell by 1.46% and the Hang Seng Tech Index shrank by 1.36%. Research from Goldman Sachs has suggested that historically, Asian markets typically demonstrate strong performances post the Federal Reserve’s initial rate cuts; however, economic recessions correlate with pronounced market weaknesses.
Investors, like Zhu Liang of Lianbo Fund Management, reported a prevailing sentiment of pessimism amidst a historically low valuation landscape. Citing the MSCI China A-share Index, Zhu pointed out that the A-share market's price-to-book ratio stands at approximately 1.55. Following previous market downturns, A-shares rebounding from price-to-book ratios between 1.4 and 1.6 commonly recorded average cumulative returns of 52% in the forthcoming two years.
After more than three years of declines, the A-share market finds itself at a historical bottom. Wu Zhaoyin, a macro strategy director at AVIC Trust, advised that regulators have promptly engaged with market sentiments and implemented measures—such as lowering stamp duties, halting IPOs, adjusting financing rhythms, encouraging dividends among listed companies, and instilling robust safeguards for long-term investment engagement—to stabilize the market. Overall, the capital outflow trends are expected to diminish. Additionally, yields on both government and credit bonds have also declined to historic lows not seen since the 2008 financial crisis, evidencing a clear bottoming pattern.