Downward and upward circuit breakers occur in quick succession, which is extraordinary, but it does happen. Why is Japan’s stock market so volatile? What causes them? On Friday, August 2, the Nikkei 225 index continued to fall 5.81% to close at 35,909.7 points, a cumulative decline of more than 8% in two days, hitting the lowest point since February 7. The Nikkei 225 was one of the world’s best-performing markets in the first half of the year. Despite its strong performance in the first half of the year, most of its gains have now been swallowed up. The stock markets of the United States and Korea are also not optimistic. On Monday, August 5, some financial markets worldwide met “Black Monday”. Among them, Japan’s stock market plunged dramatically, with the Nikkei 225 plunging 12.40%, its biggest one-day drop since October 1987. The Nikkei 225 Index has fallen 19.55% this month, the largest decline among the world’s major stock indexes. Meanwhile, Korea and Taiwan regional stock markets were not spared, with the Korea Composite Index plunging 8.77%, its biggest one-day drop since March 2020. Taiwan’s weighted index plunged 8.35%, its biggest one-day drop since July 1990. European, and U.S. stock markets also fell sharply. Following Monday’s extreme decline, Japanese stocks ushered in a violent rebound on Tuesday, rising nearly 10%. Notably, Nikkei 225 futures hit a circuit breaker upward.

So what causes the “bad days”? As for the sharp decline in the stock markets of Japan and the volatility of the global capital market, it is believed that the main reason is the front-running trade of the Fed’s interest rate cut expectations, the fear of United States economic recession, and the runaway of “hot money” due to the reduction of yen carry trades.

Some people may wonder why Japan’s stock market is so deeply connected to the United States stock market. Many of the big tech companies that make up the main force of the US stock market form a close industrial chain with Asian companies. The U.S. dollar and the Japanese yen are the two most commonly used currencies in the carry trade, making them naturally and closely linked as well.

In terms of the Fed, the belief that the Fed will cut interest rates due to the US’s weak economic performance has raised investment concerns and a trading recession. Meanwhile, the U.S. dollar index has a strong correlation with the Fed’s monetary policy cycle, and the value of the U.S. dollar may weaken at the same time, further eroding the additional foreign exchange gains that overseas investors can obtain from investing in U.S. stocks.

For the US economy, the latest non-farm payroll data ignited fears of a recession in the economy, which quickly spread to the financial markets, and US stocks continued to decline. Overseas capital outflows and the performance of leading stocks are not good. What made the market nervous was the continuous appreciation of the yen（Japanese currency）. Behind the appreciation of the yen, is the sharp ebbing of the yen carry trade. The so-called “yen carry trade” means that the yen, as one of the currencies with the lowest interest rates in the world, has been used as an important lending currency.

Borrowing low-interest yen to buy other non-yen assets with high returns is an ideal transaction. The sharp appreciation of the yen has led to the rapid arbitrage of hot money in Japan’s capital market, which is perhaps the most important reason for the yen circuit breaker.

The rapid rise in Japanese stocks on Tuesday was equally surprising. So is this the end of the decline in Japan’s stock market? The weakening of the yen has been an important factor driving the rebound of Japanese stocks, and the depreciation of the yen is conducive to improving the competitiveness of Japan’s exporters, thereby supporting the rise of Japanese stocks. Meanwhile, on the morning of 2024.8.7, the deputy governor of the Japan Bank, Shinichi Uchida, said that Japan will not raise interest rates amid financial market instability. The pace of arbitrage trade fleeing the Japan market has slowed.

At present, the Japanese stock market has maintained a relatively stable state after the rally. But Japan may eventually adopt a rate hike strategy, and the Fed’s trend of rate cuts is not going to change. A huge reduction in the yen carry trade is inevitable. The future of the stock market is still unknown. Let ’s wait and see.

By Le Tianyu