Yes, It Was a Bloodbath in the Markets Yesterday—Prepare for More

Market Moment of 1987, Bank of Japan, and the Looming Recession in the U.S.

Yesterday was a rough day for anyone in the markets, and that's probably the understatement of the century. What happened was akin to a seismic shock, leaving investors reeling and portfolios decimated.

The earthquake began in Japan, where the Nikkei index nosedived an astounding 12.4%. We haven't seen a drop like this since the infamous Black Monday crash of 1987.

As panic spread like wildfire across time zones, U.S. markets opened to a bloodbath. The Dow Jones tanked over 1,000 points, sinking 3%. The S&P 500 lost nearly $2.1 trillion in hours, ending down 3.1%. The NASDAQ Composite slid 3.6%.

This triggered panic across international markets. Overall, the global stock market wiped out over $5 trillion in a single day.

But the carnage wasn't limited to stock markets.

Crude oil plummeted to $73 a barrel, its lowest level in over a year, erasing gains made since early 2022. Many other commodities also took a hit.

The cryptocurrency sector got hammered too. Bitcoin, the leading cryptocurrency, cratered from $60,000 to $50,000 in a single day. The entire crypto market capitalization fell by nearly 20%, erasing over $300 billion in value.

So what exactly caused the turmoil?

How a Central Bank Can Break Markets

Thank the Bank of Japan for playing a starring role.

To understand how, we need to unpack the "yen carry trade." For over a decade, traders have been cashing in on Japan's rock-bottom interest rates. They'd borrow yen at these super low rates and then use that borrowed cash to invest in higher-yielding assets in other countries, especially in the U.S.

Imagine you're a trader who borrows 10 million yen when the exchange rate is 100 yen to the dollar. That gives you $100,000 to invest. You use this money to buy U.S. Treasury bonds yielding 4%. After a year, you've earned $4,000 in interest. If the yen has weakened to 105 yen per dollar, you only need $95,238 to repay your loan. You've made a profit not just from the interest rate difference, but also from the currency movement.

But, alas, good things don’t last forever.

On July 31, the Bank of Japan raised rates on short-term government bonds from 0% to 0.25%. This followed a hike in March when the bank raised the rate—for the first time in 17 years—from -0.1%.

That seemingly innocuous move was like dropping a boulder into a still pond.

It strengthened the yen, and the equation I described earlier suddenly flipped. Traders now needed more dollars to repay their loans than they initially borrowed. This triggered a massive unwinding of positions and a sell-off across various assets.

If you ever need a prime example of how connected our world is and the havoc central banks are wreaking on global economies, this is it.

We Are Not Okay

To be frank, I was struck by the U.S. market's dramatic reaction to the events in Japan. The speed and scale of the sell-off tell me that investors were already on edge, waiting for a reason to hit the panic button.

Looming recession fears were, of course, the culprit.

Clues are everywhere. From Goldman Sachs recently raising its recession expectation from 15% to 25%, to Warren Buffett selling $75.5 billion worth of Apple stock (leaving Berkshire with a massive $290 billion safety pillow). The labor market is struggling too, with unemployment up to 4.3% in July from 3.5% a year ago.

And of course, yesterday’s market crash has cranked up recession fears. Prediction markets now show the odds of a U.S. recession have almost doubled overnight to 26%.

Things seem so bad that Senator Elizabeth Warren has publicly urged Fed Chair Jerome Powell to cancel his summer vacation and cut interest rates immediately.

You can see her point... It's not a good look for the Democrats to head into the November presidential elections with the economy and markets crumbling around them.

But I doubt it’ll make a difference. Not with people like Jared Bernstein from the Council of Economic Advisors advising Biden on economic policy. Here’s a clip of him being totally out of his depth on stuff he’s supposed to be an expert in. Just a reminder of the kind of folks who got us into this mess.

Regards,

Lau Vegys

P.S. Doug Casey believes that the Fed's move to cut rates and fire up the money printer will create a bubble in commodities. That's why a big part of our Crisis Investing portfolio is focused on these stocks, which Doug himself owns.