#23. The Art of the Lure.
How the recent market volatility was played to perfection and exposed the market's hands.
Monday. Oh Monday. I don’t know about you, but usually all I want to do on Monday morning is have a nice hot coffee, get dressed, set the to-do lists in my head before heading into a new work week. Well, Monday 4th August was a little bit different.
Now in an age where the assasination attempt of a former President gets lost in the news cycle within a week, Monday 4th August will be forgotten just as quick but perhaps the ramifications of what happened will be felt longer.
The volatility in the stock market this week, starting in Tokyo, has been nothing short of a financial earthquake. The fallout from the Nikkei’s worst drop since 1987 (also a Monday) hit US shores soon after, pushing the S&P500 down 4% and the Nasdaq down 5% in pre-market trading. The fears of a meltdown sent the VIX to 65, the third highest print it’s history.
So what caused this and what does it mean going forward?
The Catalysts
Economic Data and Recession Fears:
The U.S. market has been on a knife-edge, with mixed economic signals causing widespread panic. The latest jobs report surprised many, with only 114,000 jobs added in July, pushing the unemployment rate up to 4.3%. These metrics have stoked fears of an impending recession.
Geopolitics
If the economic data wasn't enough to rattle the markets, tensions in the Middle East have added fuel to the fire. Iran is banging the war drums, and with the on-going conflict there which continues to develop and escalate, in conjunction with the simmering U.S.-China relations, we have a delicious, albeit poisonous, cocktail of uncertainty. Throw in the upcoming U.S. elections, and the Biden - Harris switcheroo, and you've got a recipe for market mayhem.
Interest Rate Hikes:
The Bank of Japan (BoJ) threw a major wrench into the works with its unexpected interest rate hike at the end of July. This move was the straw that broke the camel's back, triggering a dramatic sell-off in Japan's Nikkei 225, which plummeted by 13% at one point and closed 12.4% lower. The hike unwound yen-related trades, sending shockwaves through global markets and erasing all the Nikkei's gains for the year.
Carry Trade Unwind:
We’ll go into more detail on this below but basically, for years, investors have been profiting from the yen carry trade, borrowing in low-yielding yen to invest in higher-yielding assets. The BoJ's rate hike upended this strategy, leading to a surge in the yen's value against the U.S. dollar, which had hit a nearly 40-year high before the intervention. This sudden shift forced investors to unwind their positions, adding to the market turmoil.
The Carry Trade
I’ve been following a fellow called Michael Gayed on X for over a year now. He is the first person I saw mention the reverse carry trade, around the same time I followed. Here he is back in October 2023 detailing how Japan will kick off the crises. You see, Gayed can be very annoying but the truth is that Gayed is like most bears in a bull market, Gayed is/was early. Gayed was early, like Michael Burry was before him, but, just like Burry, he is being proven right. If his thesis is to be proven right ultimately, you might want to check him out to see where we’re going.
Part of Gayed’s theses is the unwinding of the carry trade. The carry trade, particularly involving the Japanese yen, has long been a favored strategy for investors seeking to exploit the differential between low-yielding currencies and higher-yielding assets.
Here’s how it works:
Interest rates are extremely low in Japan, close to zero.
An investor borrows money in Japan (Yen) at a low interest rate.
The investor converts the Yen into USD (for example).
The investor puts the USD into a high yielding instrument such as a high interest savings account, stocks, ETFs, etc…
The investor benefits by paying a very low interest rate to borrow the cash, whilst returning high gains.
On top of that, since 2021, the Dollar has surged over 50% against the Yen. This means that not only were investors paying low interest rates to borrow Yen, but they were actually also making FX gains on top of their high yielding gains.
To be clear, an investor could have just borrowed Yen cheaply, converted it to USD, and made 50% since 2021 by just doing nothing. So you see, the carry trade has been very profitable.
The depreciation in the Yen however put a lot of pressure on the Japanese economy, which is why when the dollar surged to a 40 year high back in April, the BoJ had to intervene, on multiple occasions, to attempt to save the currency.
By raising interest rates, the BoJ signalled a change from their long standing policy. It was the first time that the BoJ had raised interest rates since 2007. Seismic.
Now if you’ve managed to follow me this far, you probably understand how the increased borrowing rate, coupled with the knock on effect of an appreciating Yen, will impact the borrowers. As you can see the in chart above, the BoJ intervention has had the desired effect on the currency.
The interventions by the BoJ, coupled with global economic shifts, have complicated this very profitable approach. On top of that, in the west, Central Banks are already cutting rates, and there is a strong desire for the US to follow suit.
Here’s how potential rate cuts could exacerbate the carry trade unwind:
Narrowing Yield Differentials:
As we’ve seen, the essence of the carry trade is the yield differential between borrowed low-interest currencies (The Yen) and higher-yielding investments. If central banks in the west cut rates, the return on higher-yielding assets diminishes, making the carry trade less attractive. Investors might find the shrinking yield spread insufficient to justify the risk, prompting an exit from these positions. People calling for an emergency rate cut on Monday were perhaps unknowingly calling for more blood.
Stronger Yen:
Rate cuts in the U.S. or other western economies can lead to a weaker dollar and stronger yen. As the yen appreciates, the cost of repaying yen-denominated loans increases. This is known as FX risk. This added cost pressures traders to unwind their carry trade positions more quickly to avoid further losses, exacerbating market volatility.
Increased Volatility:
Lower interest rates generally signal economic concerns, such as a potential recession. Such conditions increase market volatility, which is detrimental to carry trades that thrive in stable environments. The heightened uncertainty can lead to rapid unwinding of positions as investors seek safer, more stable assets.
Risk Aversion:
During periods of economic uncertainty, typically associated with rate cuts, risk aversion spikes. Investors tend to move away from risky assets to safe havens like government bonds or gold. This flight to safety results in a mass unwinding of carry trades, as the risk-reward ratio no longer supports the strategy.
The Playbook
The move into Monday’s western trading hours was a masterpiece. As I wrote in Substack Notes;
Today's price action was a masterclass in trap setting.
Build a crescendo of fear.
Unrelented pre-market selling.
Limit down targets, ‘black monday’
Absolute monster VIX print.
All to be absolutely hammered at opening bell. The market did something very interesting today. It exposed a lot of people's hands.
The Nikkei dropped 12%. Extremely damaging and highly bearish. This set off alarm bells across the globe. The media, lapped this up, firing article after article about ‘Black Monday’, ‘Recession’, ‘Financial Unwind’, etc…This put huge selling pressure into European markets as well as American markets in pre-market trading. At one point the S&P500 was down 4% in pre-market.
Most importantly however was the VIX. The VIX, is the volatilty index, also knows as the ‘Fear Index’. The VIX printed it’s third highest reading in its history prior to the opening bell.
Only the GFC of 2008 and the Covid black swan in 2020 had higher prints. What this signalled was huge fear on Wall Street. This built a crescendo of fear into the market open. Now look what’s happened since.
The entire VIX move was retraced. So what happened? Did everyone suddenly lose their fear? Everyone bought the dip?
Well, in fact, something did happen. I believe that VIX print exposed the extent of leverage in the market and also the extent of unrealised PnL. A lot of people are levered. A lot of people did not catch those big early moves. Watch out for NVDA.
On top of that, I sense careful moves being made. If I was a conspiracy theorist, which i try not to be, I would say that the outage of major brokerage firms at opening bell was, let’s say, convenient, in order to reduce the selling pressure on the market. At the same time, institutions bought heavy, perhaps to sure up some confidence in the market.
All I know is that you don’t go from max fear to FOMO in less than 24 hours. Something is off and we’re yet to feel the full ramifications. Gayed may be right after all.
Next
So what’s next? Well, FOMO. The market is setting up a bull trap. The market is conditioning it’s willing participants to buy the dip at every correction. What we are going to see is the art of the lure. The market is going to walk up the price to a key level, S&P500 ~5,400. Get everyone frothy for more.
Then.
Brace.
Thanks for reading and I hope you enjoyed reading this piece, as much as I enjoyed writing it.
The most important thing I've read today. Thank you.