Interesting Observations from Yesterday’s Market Correction
Yesterday was a rough day in the markets. The S&P dropped about 3%, the Dow fell about 2.6%, and the Nasdaq dipped about 3.4%.
But why exactly did the market drop?
Well, it all started with a poor jobs report on Friday. But that hardly explains the level and sheer magnitude of yesterday’s selloff.
And as I shared yesterday, I figured there was something larger going on behind the scenes.
Here’s at least part of the story behind the curtain:
What we saw was an unwinding of a large volume of what’s called “Carry Trades”. Carry trades involve borrowing money in one currency with a low interest rate and investing in a different currency that has a higher interest rate.
These investors then buy and sell investments, stocks, and other assets in the higher interest-rate currency.
The currency many of these traders were using was the Japanese Yen (JPY). It’s by far the most consistent weakening currency in the world and I, myself, have traded long USD/JPY in the past for that reason.
Think about it: You’re getting the benefit of a consistently weakening currency for a stronger USD that has more buying power and collecting a net benefit on the interest — it’s a very solid macro strategy.
But then something pretty shocking happened:
Japan raised rates for the first time in nearly twenty years. As soon as they started talking about the possibility, the value of the Yen started soaring – again, the Yen is kind of known for just weakening and weakening over time.
(Chart going down means USD is weakening and JPY is strengthening)
So if you’ve got a ton of USD/JPY in your holdings and the Yen starts gaining a lot of value, your assets are getting crushed. You have to convert money back into the Yen at a worse rate than when you borrowed it.
This forced many of these carry traders to sell off their equity stocks in the US stock market to get cash back to convert back to JPY and cover their loans in very short order.
And that’s a massive reason we saw such a liquidity rug pull in the markets over the last few weeks.
Christopher Dembik, a senior investment adviser at Pictet Asset Management shared this:
“The issue at stake is not so much the market movement, it’s the scale, we’re talking about of sums which are enormous today on the carry trade.
Of course, all the carry trade won’t be unwinded in a day but given the scale, it creates structural problems.”
The reality here is that the money being pulled out of the US market was not caused by a large issue with the US market itself (not that the US market doesn’t have some issues!).
You can look at it almost like an “unfair” correction in the stock market, because equities were punished by carry traders having to yank funds out of the market.
It’s a good reminder that the stock market isn’t fair and we live in a very global economy.
On the bright side, when you look at yesterday’s chart, you’ll notice that the majority of the selling all took place in the morning and the markets trended upward slightly as the day went on. So far, that upside correction has continued.
As of now, it feels like the liquidity dump was somewhat capped to those pulling funds out of equities and not so much a snowball effect leading to more selling and pessimism.
It’s a positive sign for US stocks that we didn’t get more aggressive panic selling as the day went on.
I would consider it a healthy correction as these carry trades ejected the cash from the market that probably shouldn’t have been there and pulled funds out of the most heavily weighted indexes.
And look, today the market is up!
I don’t think we’re out of the woods yet as you’ll see from the predictions I laid out in the Tucci Trading HQ Workshop.
But for now, I am cautiously optimistic about a continued bounce.
— Nate Tucci
