What Spooked the Markets? Halloween Came Early

The selloff in equity markets was primarily triggered by two events last week

• Japan raised interest rates after leaving them mostly unchanged for years.
• U.S. unemployment rose unexpectedly, triggering fears of a recession.

Other contributing factors…

• On Thursday, the manufacturing purchasing managers’ index fell for the fourth consecutive month.
• On Saturday, Berkshire Hathaway disclosed the sale of half their Apple shares and reported record cash levels.
• Today (Monday), a news organization reported that Nvidia’s latest AI chip, Blackwell, was delayed.

Why would a change in Japan’s interest rate prompt such a big market move in the U.S.?

Since 2022, while most central banks raised rates, Japan left them unchanged and set the stage for the yen carry trade currently affecting the U.S. market today.

What is the yen carry trade?

Borrowing in yen, a currency with low interest rates, and reinvesting the proceeds in higher-yielding or higher-returning assets such as the dollar, technology stocks, U.S. Treasuries, or other higher-yielding currencies, often with leverage.

Because traders, hedge funds, and other institutions were borrowing money at cheap yen rates (around 0.2%) and reinvesting the proceeds in dollar-denominated assets, they contributed to the U.S. stock market rally. This trade worked for quite a while, particularly since the value of the yen was also falling versus the dollar.

Once Japan raised rates last week, the yen started to rise versus the dollar, causing investors to exit the trade. This meant they stopped borrowing yen and sold their stocks, sending the U.S. stock market down. There can be a snowball effect when investors use leverage, so people are worried this trade has further to go.

Why did the unemployment report contribute to the selloff?

On Thursday, the employment report showed unexpected softness, and the unemployment rate rose to 4.3%. This level caused concern because it triggered the Sahm Rule recession indicator (developed by former Federal Reserve and White House economist Claudia Sahm).

This rule reliably signals the beginning of a recession when the three-month average unemployment rate rises 0.5 percentage points or more above its lowest point in the past year.

Some economists believe this rule is less relevant today because unemployment was brought to very low historical levels post-pandemic.

Do we expect a response from the Fed?

Yes, but the type of response depends on what is actually behind the selloff.

If the market decline is a correction due to concerns about the U.S. economy, we would expect a Fed comment but no action until the anticipated cut at the September meeting. An earlier cut would cause people to worry that the economy is even worse than the data currently shows.

If the selloff is linked to a liquidity problem associated with the yen carry trade, then the Fed might cut sooner. As the chart below shows, we’ve seen this movie before in other tightening cycles.

If a liquidity event is occurring, such as the blow-up of one or more major hedge funds, it could threaten the stability of the banking system, and the Fed would typically ease quickly. Unfortunately, the very act of easing could strengthen the yen versus the dollar, causing even more pain for those involved in the yen carry trade. This presents a conundrum for the Fed.

What should investors do now?

There’s an expression: “don’t try to catch a falling knife,” which means don’t put all your money to work at the beginning of a selloff. We don’t think the selloff is over quite yet.

However, for those who are in cash or significantly underinvested, gradually adding to equities makes sense for the long term. This strategy is called dollar-cost averaging.

For those who are currently at their target allocation, the market is presenting opportunities to rebalance into stocks or sectors that were previously too expensive to own.

We remind you: panic selling is not an investment concept. Markets can rebound very quickly. If you feel panicked, give us a call. As we said in our Q2 investor letter, it could be a volatile summer.

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