Crash, panic, rout: To hear headline writers and Twitter pundits tell it, the stock market sell-off that began last Thursday, and that accelerated sharply on Monday, has been a full-fledged disaster. Investors, too, have seemed to feel a sense of panic: the VIX volatility index, often known as the Fear Index, spiked to heights seen this century only in 2008 (when it appeared the global financial system might be collapsing) and 2020 (when COVID upended the global economy). And market observers who even said the sell-off was forecasting a recession called on the Federal Reserve to hold an emergency meeting and slash interest rates by three-quarters of a point.
What real-world events prompted this level of hysteria in the markets? It didn’t take much, to be honest. The July jobs report, which came out Friday, was weaker than expected, prompting concerns that the economy is significantly decelerating and that the Fed (which did not cut interest rates when it met last week) is behind the curve in responding to it. A few of the earnings reports from big companies, including Amazon, Alphabet, and Microsoft, were arguably mildly disappointing. And the prospect of more turmoil in the Middle East has perhaps put traders on edge. But none of that would seem to justify panic.
Markets are, of course, forward-looking, and it’s possible that investors are discerning turbulence ahead that you can’t yet see in the numbers. But a more plausible explanation for what happened on Monday is that it was a sell-off propelled less by economic fundamentals and more by internal market dynamics that helped provoke a cascade of selling.
In that sense, the most important real-world event of the past 10 days had nothing to do with the U.S. economy, or American corporations. In fact, it was the Bank of Japan (BoJ)’s decision last Wednesday to raise interest rates, in an attempt to halt a slide in the value of the yen. The hike was a mere quarter of a point. But the BoJ indicated that future hikes might be in store. And that seemingly minor decision had a major impact on the global market, by accelerating the global unwinding of the so-called yen carry trade.
Over the past couple years, Japanese interest rates have remained extraordinarily low relative to the rest of the industrialized world. (Before Wednesday’s hike, the Bank of Japan’s target interest rate was between 0 and 0.1%.) So hedge funds have been borrowing yen at low rates and using the proceeds to buy stocks in the U.S. and elsewhere. The BoJ’s interest-rate hike signaled that the era of cheap money may be coming to an end. It also amplified a recent rise in the value of the yen, which has made it much more expensive for hedge funds to buy the yen they need to pay back their loans. And that prompted at least some funds to exit their carry trades, raising the cash by selling off U.S. stocks.
Exacerbating these dynamics is the fact that in today’s market, there’s lots of crowding into seemingly successful strategies like the carry trade, with hedge funds effectively imitating each other. So when events occur that disrupt those strategies, you have lots of players trying to get out at the same time. That can create a vicious cycle for traders. In the case of the yen, for instance, as the value of the yen rose, hedge funds bought it to cover their loans. That sent the price of the yen higher, forcing more funds to buy it, sending the price higher.
Similarly, hedge funds have crowded into big technology stocks, including most notably the so-called Magnificent Seven tech stocks. Just last week, Deutsche Bank analysts wrote that the concentration of hedge-funds’ and other institutional investors’ positions in growth stocks (including the Magnificent Seven) was at the 97th percentile of historical trends. So as these funds sell off assets to raise cash and deleverage, tech stocks are inevitably going to take a hit: at one point on Monday, the Mag Seven were down almost 10% collectively.
That decline also reflects the fact that Big Tech valuations had gotten a bit stretched, in part because fund managers have been piling into these stocks in order to make up for having missed out on their big rise in 2023. Less than a month ago, for instance, the Magnificent Seven were up 37% year to date; while chipmaker Nvidia, the biggest gainer of the bunch, was up 185% on the year. When stocks are trading at high valuations, even small changes in future expectations can result in big price swings. Combine that with the carry-trade unwind, and you can easily see the kind of stock market drop we saw on Monday.
That doesn’t mean that anxiety about the state of the economy had nothing to do with the sell-off. But the fact that the stock market rebounded strongly on Tuesday suggests that recession worries are not the main reason traders have been selling since the economy looked no better (or worse) on Tuesday than it did the day before. More to the point, calls for an emergency rate cut are out of place. The stock market has had a remarkably smooth ascent for almost two straight years. And it’s not the Fed’s job to step in every time things get a little bumpy for investors. The Fed should (and almost certainly will) cut rates next month. But it should do so because that’s what the economic data is telling it to do, not because some hedge-fund managers got caught on the wrong side of a trade.