Markets recovered very quickly from the August bloodbath. However, the central bank consortium warned that the market's woes are not over.
A partial unwinding of the so-called yen carry trade on August 5 caused global market panic.
On that day, Japan's Nikkei and TOPICS — the country's two largest stock market indexes — lost more than 12%, marking their worst day since the 1987 market crash. The S&P 500 and Nasdaq, meanwhile, fell 4.2% and 6.3%.
Since then the markets have bounced back and all is well. But it? The underlying issues behind the sell-off remain unchanged, an influential consortium of world central banks warned policymakers on Thursday.
Even if markets avoided a complete collapse this time, “the structural features of the system underlying such episodes deserve continued attention,” the Bank of International Settlements report said.
Meeting margin calls
Investors take advantage of Japan's low interest rates to borrow yen and buy high-yielding US equities and bonds – a strategy known as a “carry trade”.
While the size of the yen carry trade is hard to say, the BIS estimates the value of yen-denominated loans to investors outside Japan to be at least $250 billion as of Aug. 5. But that number may be an underestimation. , BIS warns of data gaps.
In late July, the Bank of Japan announced that it would raise interest rates to combat inflation. The move caught currency traders flat-footed as they had to sell their US holdings to pay interest on borrowed yen.
Why the turmoil rocked unrelated markets like cryptocurrencies, the BIS report said. Both Bitcoin and Ethereum fell by as much as 20% in the following days.
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“The impact of the freeze reverberated across multiple currencies, reflecting the use of multiple sources of funds and investments by carry traders,” the report said.
Markets rebounded
But the markets ultimately proved resilient, the report said, adding that “the speed of their recovery was remarkable.”
Exchange rates did not fluctuate wildly, forex volatility did not increase as much as equities, and trading in US markets continued without interruption.
However, BIS has urged caution, saying the underlying issues behind the sale have not changed much.
The report said only a few trades “looked like yes” on low-volatility and cheap yen funding.
BIS said some of these leveraged positions are being restructured.
More worryingly, there are broader, structural factors. Markets allow large, risky positions to be built up during calm periods, only to be quickly liquidated when volatility increases.
“The reliance of many of these positions on leverage suggests that investors may have to react more strongly to adverse shocks to avoid significant losses,” the BIS researchers wrote.
“If such behavior takes place in a chaotic and illiquid market environment, volatility may worsen and trigger a negative feedback loop.”
Joanna Wright writes about markets News. Email her [email protected].