Market Volatility Update

The months of July and August so far this year have seen increased volatility across financial markets. I wanted to share some brief commentary on what caused stock markets to dip in July, and how they have performed since then.

How much did the markets dip?

Since the start of the year, major stock markets in the US have performed exceptionally well. The NASDAQ, which is heavily weighted towards tracking technology companies, reached it's peak on July 9th with a YTD performance of +24.22%. Similarly, the S&P 500 index reached it's peak on July 15th up +18.06%. 



From this point onward to early August, the NASDAQ and S&P 500 went on to drop -13.15% and -8.49%, respectively. In only a couple of weeks, this was a fairly quick correction and caused some panic selling. 



So what caused this rapid selloff?

You may have heard about this in the news, but the main cause of the recent selloff is something called the "yen carry trade" unwinding. Let me explain.

The yen refers to the Japanese currency, while carry trade refers to the operation of investors borrowing a currency in one jurisdiction with low rates, and reinvesting into higher yielding assets. A quick example of how this might look:

eg. Nick goes to Japan and borrows $1M for an extremely low rate - let's call it 1%, and subsequently converts it into USD and invests in US government debt yielding 5%. In this scenario, Nick has profited $40,000/year or 4% on his $1M investment. (5% yield minus 1% cost of debt)

It might sound like easy money, but how could it go wrong? Well, ultimately you have two main risks:

1. If the interest rate on your debt goes up making the trade less profitable
2. The currency in which you originally borrowed starts to appreciate against the currency your invested assets are denominated in. 

Since the Japanese yen has historically depreciated against the USD, and their bank lending rate has stayed extremely low, this made it a perfect candidate for sophisticated investors to try to capitalize on this trade. Ultimately, the bank of Japan started increasing their bank rate, which caused their currency to appreciate, which is the exact problem these sophisticated investors wanted to avoid. Because of this, they are forced to "unwind" the trade, selling their assets, converting back to Japanese yen and repaying their debts. All of this caused such a sharp selloff, as risk departments across these financial institutions all sound the alarm at the same time. 

What is the conclusion?

Since the sharp drawdown the markets witness over the last two weeks of July, the first two weeks of August saw a similar type of move back in the upward direction. The S&P 500 and Nasdaq are now only down -1.28% and -4.52% from their previous highs. I think this just goes to show you that when sharp, quick corrections happen in the market, it's best not to overreact.

Best,

Jon

Jonathan Adomait
Financial Planner | CFP, CIM, B.Eng