The recent market volatility has left many wondering what caused it and what will happen next. One of the key factors contributing to this volatility was the decision by the Bank of Japan to raise interest rates by 0.25%. This seemingly small increase had far-reaching effects, resulting in trillions of wealth being lost. The Japanese economy has been struggling with deflation for years, leading the BOJ to slash interest rates to zero and even into negative territory. Japanese investors sought higher yields overseas, investing in bonds and other assets in countries with higher interest rates.
To protect their investments from currency depreciation, Japanese investors typically hedge their foreign currency assets. However, this hedging can be costly, as it involves factors like interest rate differentials and basis swaps. As Japanese rates remained low and US rates were higher, hedging became expensive and eroded the carry that investors received from their investments. In response, many investors chose not to hedge their currency risk, increasing their exposure to foreign exchange fluctuations.
With inflation on the rise in Japan, the BOJ faced a dilemma. Raising interest rates could lead to money returning to Japan, causing foreign assets to be sold and resulting in losses for investors. To combat inflation, the BOJ had been buying up government bonds and even investing in the stock market. However, the new chief of the BOJ made the decision to raise interest rates, signaling a shift in policy. This decision, combined with other factors like the US Federal Reserve potentially cutting rates, created a domino effect that led to a surge in market volatility.
The increase in market volatility had widespread implications, impacting various trading strategies that rely on low volatility. Systematic strategies like volatility targeting and risk-parity had to de-risk as volatility rose, contributing to the overall market turmoil. The deputy chief of the BOJ attempted to reassure markets by suggesting that they would not raise rates if volatility persisted, highlighting the delicate balance that central banks must maintain in navigating economic challenges.
As central banks grapple with rising inflation and changing market conditions, the laws of financial gravity come into play. In Japan, rising rates are expected to strengthen the yen and weaken the dollar, leading to losses for Japanese investors holding foreign assets. In the US, an inverted yield curve and negative carry present challenges for market functioning. The central banks are faced with tough decisions, and market forces are likely to drive their actions in the coming months.
Overall, the current environment points to increased volatility and uncertainty in the markets. Investors are advised to tread carefully and be prepared for further turbulence as central banks navigate shifting economic conditions. The road ahead is paved with challenges, but for those who understand the implications of the carry unwind and market forces at play, there may be opportunities to navigate the volatility and protect their investments.
