This is Dominic Pino filling in for Jim Geraghty. I’ll be turning the Jolt over to Noah Rothman tomorrow.
On the menu today: What happened in the stock market yesterday, which caused one of the biggest sell-offs in recent memory. It didn’t have anything to do with American politics and had less to do with the American economy than you might think.
What Happened
The July U.S. jobs report was not great. Job gains were only 114,000 for the month, less than expected, and the unemployment rate rose to 4.3 percent, up from 4.1 percent in June.
But you would be hard-pressed to find anyone who seriously believes that 4.3 percent unemployment is cause for recession fears. For decades, an unemployment rate around 4 percent was considered full employment. The U.S. has had an unusually low unemployment rate for the past two years.
The uptick in the unemployment rate does not undo other economic indicators. Just before the jobs report, on July 25, the Bureau of Economic Analysis released its real-GDP estimates, which said annualized growth had increased from 1.4 percent in the first quarter to 2.8 percent in the second quarter. If you’d told someone last year, let alone last decade, that a 4.3 percent unemployment rate and rising estimates of GDP growth would have some people worrying about a recession, he would’ve looked at you like you were crazy.
The idea that the global stock market looked at July’s jobs report and decided to massively sell off stocks based on that alone simply does not make sense. Looking closer, we can see the real factors that caused the decline.
Many major investors, especially in hedge funds, were overleveraged due to a tactic called “carry trading.” The basic principle of investing is buy low and sell high. That’s easy enough to understand with one currency, but it can become more complicated in the real world, where there are many currencies.
It can sometimes help to increase the gap between low and high, and therefore an investor’s return, by borrowing in a different currency from the one the asset that you’re buying is sold in. If the interest rate in one country is much lower than the interest rate in the country you’re trying to buy in, borrowing in the first country can lead to a higher return in the second country, even after paying back interest for the loan. Executing that strategy is called making a “carry trade.”
Japan has had extraordinarily low interest rates for a long time. The Bank of Japan’s policy rate was recently still below zero (yes, the interest rate was negative) while the Federal Reserve’s federal funds rate rose to over 5 percent. This gap provided investors with opportunities to make carry trades by borrowing in yen and then buying high-growth U.S. stocks in dollars.
And investors took advantage of those opportunities, to the tune of $4 trillion worldwide.
That works until it doesn’t. And it recently stopped looking like such a great idea, because the Bank of Japan started to raise interest rates. In March, it raised its policy rate for the first time in 17 years. Then, on July 31, when markets were expecting Japanese interest rates to stay the same, Bank of Japan governor Kazuo Ueda announced another rate increase along with a reduction in the bank’s balance sheet, and hinted at the possibility of more rate hikes in the future.
All of a sudden, the gap between the dollar and the yen that carry traders had been exploiting began to vanish. The yen rose against the dollar in the foreign-exchange markets. Even though the dollar was still worth much more than the yen, the gap was no longer large enough for the carry trades to pay off, and the Bank of Japan’s speculation on further rate hikes signaled that the gap would become even smaller in the future. So investors began to sell in large quantities.
“The rise of Japan interest rates is changing the game rules,” the head of research at one brokerage told Bloomberg. “In essence it’s the end of a free resource.”
As the carry trades began to unwind, the hedge funds that made them in large quantities had to also sell other assets to satisfy their risk models, the Wall Street Journal reported. That’s one way the sell-off spread to other areas of the market. The decline in the valuation of the largest technology stocks also led non-carry traders to sell for other reasons, such as perceived over-optimism in artificial intelligence and a simple increase in overall risk and volatility. Investors flocked to safe, lower-return assets such as government bonds instead.
What Happens Next
You’ll notice that none of this has anything to do with the presidential election, or American politics at all. That’s a very good thing. You don’t want to live in a country where stock-market performance is determined by politics.
Some of the best evidence that we still live in a free-market economy is that Big Tech, hated by Trump, performed very well during his presidency, and Big Oil, hated by Biden, has been performing very well during his. If you can make a bunch of money investing in companies that the president hates, that’s a pretty good sign you live in a free country.
Expect some politician or regulator somewhere to call for banning or restricting carry trades, a thing that he or she had probably never heard of before yesterday. Carry trades aren’t some newfangled idea. The Federal Reserve Bank of San Francisco was writing about them in 2006, and they have been popular with some investors since at least the 1990s.
Also expect people to demean carry trades as some sort of highly theoretical maneuver that doesn’t work in the real world, when the exact opposite is true. According to economic theory, carry trades should not ever make money, because exchange rates between countries should adjust automatically to reflect the difference in interest rates. It’s the gap between theory and the real world that investors exploit with carry trades.
Despite the large number of points the markets lost, the actual percentage decline wasn’t that large because it came after years of rallying. As NR’s editorial today points out, the 3 percent decline in the S&P 500 yesterday was the largest single-day drop since . . . 2022. Remember the massive depression of 2022? Yeah, that didn’t happen.
Asian markets this morning have recovered a big chunk of the ground lost yesterday, with the Nikkei up 10 percent today after losing 12 percent yesterday. U.S. stock futures were also up significantly overnight.
It’s still possible that a recession is coming soon, and one is guaranteed to come eventually. But when it does come, it won’t be because of what happened yesterday in the stock market.
Don’t look at your retirement account. Looking won’t help, and it might encourage you to make poor snap decisions. As one analyst noted for Bloomberg, stocks have risen in 33 of the past 40 years, with an average return of 13 percent. With higher returns comes higher risk, and days like yesterday are part of investing in the stock market.
ADDENDUM: Check out this crazy ping-pong shot from the men’s gold-medal match at the Olympics. The guy who made it, Sweden’s Truls Möregårdh, ended up losing the match and settling for silver, but he upset the No. 1 player in the world earlier in the tournament. It might seem weird for a game you might play in your basement to be in the Olympics, but watching the competition makes clear that these athletes are on another level. And I commend to you Jack Butler’s recent piece against Olympics cynicism.