Last week’s disappointing U.S. July jobs report sent ripples through global markets. Particularly large moves were seen in Japanese markets, which dropped 6% on Friday (8/2) and another 12% on Monday (8/5), marking the worst daily sell-off since 1987. On Tuesday, Japanese equities rebounded 10%, the best day since 2008. Equally staggering are the recent movements in the Japanese Yen which has strengthened 11% since June, after being down 12% on the year. What’s behind this volatility in Japanese markets? A mixture of changing fundamentals, plus powerful technical factors, have exacerbated moves in previously big winners, including Japanese equities. However, the long-term case for Japanese equities has not changed, especially around better earnings growth and corporate governance changes, and valuations have improved as the price-to-earnings multiple moved down to 12x, below its 10-year average.

Global markets, including Japan, are adjusting to potentially softer growth in the U.S. and larger Fed rate cuts, while the Bank of Japan ramps up its monetary policy normalization by raising rates. However, the magnitude of these market moves suggests there is more going on beneath the surface than fundamentals alone. Carry trades, or borrowing in a less expensive currency like the Yen to invest elsewhere, like Japanese equities or megacap tech stocks in U.S., became very popular over the past 18 months. As Japanese interest rates moved up and Yen volatility surged, these carry trades began to unwind rapidly. Investors unwinding carry trades have to sell investments to cover JPY short positions, contributing to further Yen strength. In fact, this has been occurring in other markets with cheap funding currencies (like the Swiss Franc which has appreciated by 5% since the end of June) and in other previous high-flyer markets (like “Magnificent 7” stocks and Mexican and Brazilian local currency bonds).

The triggers for this Yen carry trade unwind are:

1. Narrowing U.S. vs. Japan interest rate differentials: The difference between the 10-year U.S. Treasury yield and the 10-year Japan government bond yield has narrowed from 3.43% in late June to 2.99% now, strengthening the yen. Softer U.S. economic data caused the U.S. 10-year Treasury yield to drop to 3.78%, its lowest level since July 2023, while the Bank of Japan has been tightening monetary policy, causing yields to increase. Historically, these interest rate differentials have been closely correlated to Yen moves versus the U.S. dollar.
2. Higher currency volatility: The implied USD/JPY volatility rose, with the 1-month implied exchange rate volatility rising to 15.6%, much higher than the year-to-date average of 8.9% and 10-year average of 8.6%. This decreases the attractiveness of the carry trade.
3. Higher funding costs in Japan: With its rate hike last week, the Bank of Japan has brought short-term rates in Japan to 0.25%, and 10-year yields have moved up to 1.10% in July. This increases the funding cost for carry trades.

Investors are likely wondering when this volatility may subside. Given the popularity of this trade, we may yet see some more volatility related to it. However, for long-term investors, it is key to realize that the fundamental case for investing in Japan has not changed. After a long malaise, Japan’s economy is now seeing positive nominal growth, which should lead to better revenue growth. 2024 earnings growth is still expected to be 13% y/y in local currency terms. The Yen’s appreciation may shave off a bit from earnings expectations; however, corporate governance reforms should continue to inject more long-term dynamism into Japanese companies. On the positive side, multiples have contracted, moving from 15x to 12x, below the 10-year average. 

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