From July 2024 to the present, the global financial market has welcomed a new wave of turmoil. The main manifestations are: First, the global stock market, represented by the U.S. and Japanese stocks, has plummeted, with the VIX index, which reflects the degree of stock market volatility, soaring; Second, the global risk-free long-term interest rates have fallen, for example, the yield on 10-year U.S. Treasury bonds has dropped from around 4.20% to around 3.75%; Third, the U.S. dollar index has declined, with the depreciation of the U.S. dollar against the Japanese yen being the most significant. For instance, from July 10 to August 5, the exchange rate of the U.S. dollar against the Japanese yen fell from 161.73 to 143.95, a depreciation of 11%. In addition, the CNH exchange rate of the U.S. dollar against the Chinese yuan has also fallen significantly; Fourth, global gold and crude oil prices have fallen sharply; Fifth, all of the above indicators have shown a deep V-shaped trend of first falling sharply and then rebounding significantly, which usually implies that short-term financial indicators have overshot beyond the extent that can be explained by fundamentals.

In my view, there are four main explanations for the recent turmoil in the global financial market. First, the Bank of Japan's interest rate hike has led to a large-scale closing of yen-carry trades. Driven by high domestic inflation, from March 2022 to July 2023, the Federal Reserve raised interest rates 11 times in less than a year and a half, with a total increase of 525 basis points. During the same period, due to sluggish economic growth, the Bank of Japan remained inactive. The above monetary policy differences led to a rapid widening of the U.S.-Japan interest rate differential, thus triggering a new round of yen-carry trades.

Advertisement

This round of yen-carry trades can be roughly divided into three layers:

The first layer of carry trade is where investors borrow yen and then exchange it for U.S. dollars, arbitraging the interest rate difference between the two, resulting in a depreciation of the yen against the U.S. dollar; The second layer of arbitrage trade is where investors borrow yen, exchange it for U.S. dollars, and then use the U.S. dollars to buy U.S. stocks, enjoying both the U.S.-Japan interest rate spread and the rise in the U.S. stock market, resulting in a depreciation of the yen against the U.S. dollar and an increase in U.S. stocks; The third layer of arbitrage trade is where investors borrow yen with U.S. dollars as collateral, and then use the yen to buy Japanese stocks, enjoying both the U.S.-Japan interest rate spread and the rise in the Japanese stock market, resulting in a depreciation of the yen against the U.S. dollar and an increase in Japanese stocks. In addition, investors will use leverage to amplify the returns of yen-carry trades.Starting from 2022 to the present, the exchange rate trend between the US dollar and the Japanese yen has shown a high positive correlation with the interest rate differential trend between the US and Japan, and the interest rate differential changes usually precede the changes in the US dollar to yen exchange rate. This is the first piece of evidence for the existence of arbitrage trading. As shown in Figure 2, from 2023 to the present, the positive correlation between the US dollar to yen exchange rate trend and the NASDAQ index trend has significantly strengthened, which is the second piece of evidence for the existence of arbitrage trading. As shown in Figure 3, from 2023 to the present, the positive correlation between the US dollar to yen exchange rate trend and the Nikkei 225 index trend has significantly strengthened, which is the third piece of evidence for the existence of arbitrage trading.

The significant depreciation of the yen against the US dollar caused by the new round of yen carry trades, although beneficial for boosting Japanese exports and promoting the rise of the Japanese stock market, will worsen Japan's trade conditions and bring pressure of imported inflation. Against this backdrop, the Bank of Japan began to respond by raising interest rates and intervening in the foreign exchange market. On the one hand, the Bank of Japan raised interest rates twice in March and July of this year.

In March, the Bank of Japan increased the policy interest rate from -0.1% to 0-0.1%, marking the first interest rate hike by the Bank of Japan since February 2007. On July 31, the Bank of Japan raised the policy interest rate from 0-0.1% to 0.25%, and this interest rate hike directly led to the escalation of this round of global financial turmoil. On the other hand, the Bank of Japan intervened in the foreign exchange market several times in May and July of this year.

The interest rate hikes and interventions by the Bank of Japan have led to a significant narrowing of the US-Japan interest rate differential. For example, the difference in the yield of 10-year US and Japanese government bonds narrowed from 381 basis points on April 30, 2024, to 283 basis points on August 2, a decrease of nearly 100 basis points. The significant narrowing of the interest rate differential has caused investors who entered the carry trade with high leverage later to suffer losses first, thus having to close their positions.

The closing operations will lead to a decline in the US dollar to yen exchange rate, as well as a decline in US and Japanese stocks. Once the US dollar to yen exchange rate falls, it will expand the loss range of carry traders, thus triggering a larger scale of closing operations. This forms a new vicious cycle.

Secondly, recent data shows that the pressure of economic recession in the United States is increasing, and the market is worried that if the Federal Reserve does not cut interest rates in time, it may trigger a large-scale economic recession.

In May, June, and July 2024, the unemployment rates in the United States were 4.0%, 4.1%, and 4.3%, respectively. Compared with 3.4% in January and April 2023, the unemployment rate in July increased by nearly one percentage point. In July 2024, the year-on-year growth rate of the US CPI fell to 2.9%, which is the first time the data has been below 3% since April 2021. In the same month, the year-on-year growth rate of the core US CPI (3.2%) also reached a new low since May 2021.

In July 2024, the decline in the US unemployment rate triggered the Sam Rule. The so-called Sam Rule refers to the situation where the average of the US unemployment rate in the most recent three months is more than 0.5 percentage points higher than the low point in the past 12 months, indicating that the United States has entered the early stage of an economic recession.

Since 1950, the Sam Rule has been triggered a total of 11 times, and it has been verified to be 100% effective. For example, it was triggered for the 10th time in January 2008, and for the 11th time in April 2020. In July of this year, the rule was triggered for the 12th time. There are two reasons why the Sam Rule has a high accuracy rate: on the one hand, in the early stages of a recession, unemployment statistics tend to underestimate the unemployment rate; on the other hand, an increase in the unemployment rate will lead to a slowdown in the growth rate of real wages, which will reduce total demand. The reduced total demand will further lead to an increase in the unemployment rate and a slowdown in the growth rate of real wages. Therefore, the unemployment rate is a variable with a self-perpetuating trend. When it starts to rise significantly, it often continues to rise.The market once feared that the Federal Reserve's first interest rate cut would be delayed until December of this year. However, after the release of the data in July, the market now believes that the probability of the Federal Reserve cutting interest rates in September this year is almost 100%, and the market has raised its judgment of cumulative interest rate cuts of 50 basis points within this year to 100 basis points. Therefore, if the Federal Reserve cuts interest rates later than expected or the magnitude of the cut is weaker than expected, it could lead to new turmoil in the financial markets.

Third, the uncertainty surrounding the U.S. presidential election has increased. After the first presidential debate on television this year, the market showed a consistent trend of favoring Trump and looking down on Biden, and even initiated the "Trump trade." However, after Biden announced his withdrawal from the election on July 22 and was replaced by Harris, the uncertainty of the results of this round of the U.S. presidential election has risen again. For example, several recent polls have shown that Harris's support rate is slightly higher than Trump's.

Fourth, investors' concerns about the sustainability of U.S. high-tech stock prices are continuously increasing. As we all know, the bull market in the U.S. stock market in the past few years has been largely driven by the so-called "Seven Sisters" (Mag7), and is largely related to the market's optimism about artificial intelligence technology. In July this year, Goldman Sachs released a research report questioning whether the trillion-dollar artificial intelligence expenditure can bring about an increase in the operating income of related companies. This view has been echoed by many investors, leading to significant fluctuations in the stock prices of the "Seven Sisters" in recent times, especially NVIDIA.

Where will the current global financial market turmoil go in the future? The author believes that in the short term, the peak pressure of the yen carry trade has passed, and the U.S. economy still has a certain resilience, so the possibility of the current global financial market turmoil continuing to ferment and leading to a new round of crisis is relatively low, but the increase in global financial market volatility is still a high probability event.

Firstly, the peak pressure of the yen carry trade has passed. Based on the current estimates of various investment institutions, the scale of the yen carry trade is between 300 billion and 500 billion U.S. dollars, of which 150 billion to 250 billion U.S. dollars of funds are more active. Currently, JPMorgan and UBS believe that two-thirds of the yen carry trade has been completed, while Goldman Sachs believes that the trade has basically ended. In addition, according to the non-position data of the CFTC, the net short position of the yen reached a historical peak of 184,000 contracts at the beginning of July, and has dropped to 11,000 contracts by around August 6.

Secondly, the probability of a soft landing of the U.S. economy is still relatively high. First, although the current U.S. unemployment rate has risen to 4.3%, from an absolute level, it is still quite close to the natural unemployment rate. In addition, the U.S. labor force participation rate in July rose to 63.2%, the highest level since March 2020, indicating that a large part of the labor force that once exited the labor force after the outbreak of the COVID-19 pandemic has returned to the labor market. Second, with the decline of the inflation rate and the core inflation rate, the space for the Federal Reserve to cut interest rates is expanding. The timing of the Federal Reserve's interest rate cuts within this year may be advanced, and the magnitude may be increased. Third, the current real expansionary strength of U.S. fiscal policy is still relatively large.

Again, although the probability of a global financial crisis is relatively low, the increase in global financial market volatility is a high probability event. First, considering that the stock price performance of the "Seven Sisters" in the past few years has formed a sharp contrast with the stock price performance of many traditional industries, the author believes that in the coming period, the questioning of high-tech stocks such as AI will continue, and it is not ruled out that U.S. high-tech stocks will repeat the significant adjustment pattern of 2022; second, in the second half of this year, the uncertainty of the U.S. election, the subsequent development of the Russia-Ukraine conflict and the Israel-Palestine conflict, etc., may have a significant impact on investor sentiment; third, the pressure of high interest rates on the rigid interest expenditure of the U.S. government is beginning to emerge, and the market's concerns about the sustainability of U.S. sovereign debt are also intensifying; fourth, the Bank of Japan may continue to raise interest rates. In summary, safe-haven assets such as gold still have room for price increases in the future.

Finally, the depreciation pressure of the renminbi against the U.S. dollar is expected to continue to ease. In the first half of 2024, the depreciation pressure of the renminbi against the U.S. dollar increased, which was reflected in the continuous widening of the onshore and offshore exchange rate difference of the renminbi against the U.S. dollar, and the continuous widening of the exchange rate difference between the midpoint and the closing price of the renminbi against the U.S. dollar. In the past month, with the decline of the U.S. dollar index, the offshore price and onshore closing price of the renminbi against the U.S. dollar have both appreciated significantly, and have basically converged to the midpoint. The author believes that in the coming period, the midpoint of the renminbi against the U.S. dollar is expected to stabilize around 7.1, and the closing price of the renminbi against the U.S. dollar is expected to converge to around 7.1-7.2.It seems like there was an error in the text you provided. There is no content to translate. Please provide the text you would like translated into English.