The wild swings in markets recently are a case study in how seemingly distinct pillars around the globe are connected through the financial system — and the domino effect that can follow if one of them falls.
Some of the turmoil in stocks reflected rising fear that the American labor market may be cracking, and that the U.S. Federal Reserve may have waited too long to cut interest rates.
But it’s more complicated than that. This time around, there are also more technical reasons for the sell-off, analysts and investors say.
Factors like a slow buildup of risky bets, the sudden undoing of a popular way to fund such trades and diverging decisions by global policymakers are each playing a role. Some of these forces can be traced back years, while others emerged only recently.
Here are some of the key reasons for the swings.
A long stretch of low interest rates led investors to take more risks.
The buildup of risks in the financial system can partly be traced back to 2008, when the housing crisis prompted the Federal Reserve to cut interest rates aggressively and keep them low for years. That encouraged investors to seek returns from riskier bets, since borrowing was cheap and cash parked in safe assets like money market funds earned next to nothing.
Rates were also cut back to near zero in the early stages of the coronavirus pandemic, reviving these sorts of trades.
As the Fed began to raise rates rapidly in 2022, this dynamic shifted, putting the riskier bets under pressure as the returns on relatively safe investments became more attractive.
But not all countries raised interest rates at the same time. In Japan, where growth and inflation had long languished, the central bank kept its rates near zero, making it an outlier.
This made the yen very cheap relative to other currencies, and investors spotted an opportunity: Borrow money cheaply in Japan and put it toward higher-yielding investments elsewhere around the world.
Known as a carry trade, this investment strategy “was one of the darling trades among hedge funds and other investors,” said Christian Salomone, the chief investment officer of Ballast Rock Private Wealth. Its undoing has also become a major factor in the recent market turmoil.
A stronger yen has prompted a ‘punishing unwind’ of popular trades.
When the Bank of Japan raised interest rates last week, for only the second time in nearly 20 years, the decision coincided with forecasts that the Fed was preparing to cut rates soon. This narrowed the gap between market rates in Japan and the United States, and the yen spiked.
A truly enormous amount of money has been borrowed in yen by investors outside Japan, with economists at the European bank ING estimating that these cross-border loans have increased by more than $700 billion since 2021. The sharp rise in the yen led to a “punishing unwind of carry trades,” analysts at Goldman Sachs wrote in a research note on Tuesday.
The suddenly stronger yen also threatened to become a drag on corporate profits for Japanese firms, especially the big companies that rely on exports. That spooked investors in Japan’s stock market, stoking fears that a stronger yen would spell the end of a more-than-yearlong rally. The three-day loss of more than 20 percent for Japanese stocks, through Monday, was the largest since 1950, according to Goldman.
Many investors and analysts point to the turmoil in Japan as the catalyst for the recent global sell-off, compounded later by investors’ anxiety about the direction of the U.S. economy and other worries.
Investors are questioning their assumptions on how high some stocks could rise.
As yen-based carry trades began to unravel, pulling stock prices lower, some investors began to reassess whether the barnstorming rally in shares of big tech companies had gone too far.
Tech stocks propelled markets higher in the first half of this year, with almost two-thirds of the S&P 500’s gain linked to a handful of stocks that became known as the “Magnificent Seven”: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
But that dominance has left the market vulnerable to a shift in sentiment about these giants’ ability to meet such high expectations. Investors are getting worried about when they will see a return on the huge amounts that these firms have committed to spend on artificial intelligence.
From its peak on July 16 through Monday’s close of trading, the S&P 500 fell 8.5 percent, and more than half of that loss could be attributed to the Magnificent Seven, according to data from Howard Silverblatt at S&P Dow Jones Indices.
Some influential investors have also scaled back. Berkshire Hathaway, the conglomerate run by Warren E. Buffett, halved its multibillion-dollar stake in Apple last quarter, according to a weekend filing.
Other arcane strategies, and thin trading volumes, make for volatile trading.
Some investors trying to make sense of the sharp moves in markets have also pointed to the role played by specialist derivatives traders who bet not on the direction of price movements but on the magnitude of volatility in those changes. Bets on low volatility, a winning strategy for much of the year as stocks marched steadily higher, came under pressure as the sell-off erupted. That may have forced further selling as investors tried to cover their losses.
A rise in volatility can also be a function of the calendar. Summer vacations result in lower trading volumes on Wall Street, so nudges up or down can have an outsize effect on market prices.
The “violent moves of recent days,” Jim Reid, a strategist at Deutsche Bank, wrote in a note this week, were “massively exaggerated by illiquid August conditions.”