Summer Turbulence in the Global Financial Markets: Insights into the Dramatic Movements

The global financial markets have experienced a tumultuous summer. Stock indices in the US and Japan witnessed a rapid plunge on Friday and Monday, followed by a partial recovery. Simultaneously, yields on US Treasury bonds and global currencies fluctuated significantly. An indicator of expected volatility for the US stock market rose to its highest level since the Covid-19 pandemic in 2020, reflecting investor nervousness. "Some of the movements we have seen in the past few days have been historically remarkable," commented Ben Powell, Chief Investment Strategist at BlackRock Investment Institute for the Asia-Pacific region. Weak US labor market data on Friday may have triggered the recent market fluctuations, "but there was also plenty of kindling," he added. Japan was at the center of the storm, partly due to its strong market performance this year. Three weeks ago, the Topix index reached an all-time high, driven by renewed interest from international investors in Japanese stocks. The situation changed drastically when the Bank of Japan raised interest rates to the highest level since 2008 last week, causing the yen to appreciate sharply. As the currency strengthened, the Topix plunged 12.2 percent on Monday, wiping out its annual gains — the steepest drop since "Black Monday" in October 1987. The following day, the index recovered by 9 percent, but remains well below its recent peak. Major tech stocks had already suffered during the latest earnings season, as the sector, which had fueled the bulk of this year's Wall Street gains, failed to meet investors' inflated expectations. Affected by the global sell-off, the so-called "Magnificent Seven" — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla — lost around one trillion dollars in market capitalization over two days. Freya Beamish, Chief Economist at TS Lombard, commented, "It is the stock markets, not the US economy, that need a correction. The bubble in the markets was obvious, with a huge reliance on a few very highly valued stocks." The sell-off on Friday and Monday extended far beyond the tech sector, affecting banks, industrial stocks, small businesses, and cyclical consumer goods — a significantly broader decline than previous market setbacks this year. A closely watched indicator of the extent to which US stocks rise or fall together surged, as stock markets broadly moved in unison downwards. The panic was also reflected in the Vix index of expected turbulence in the S&P 500, known as Wall Street's "fear gauge." The index rose to its highest level since the early phases of the 2020 pandemic, as investors reacted to wild swings in the stock and bond markets. The US Treasury markets have been sending a recession warning signal for over two years. The "inversion" of the yield curve — where two-year borrowing costs exceed ten-year costs — typically indicates an impending recession. This inversion briefly reversed during the peak of market turmoil on Monday after weak US labor market data on Friday spurred fears of an impending economic slowdown, leading to violent reactions in the bond markets. On Monday morning, "US Treasuries were pricing in a recession and aggressive Fed rate cuts," explained Mike Zigmont, Head of Trading at Harvest Volatility Management. "But by the afternoon, bonds were behaving as if it was just a boring day." In early July, the yen reached its weakest level against the dollar in over 34 years, due to diverging interest rates in Japan and the US. This encouraged investors to engage in speculative trades, borrowing cheap yen to fund high-yield bets elsewhere. However, the yen began to rise in July and surged last week when the Bank of Japan raised borrowing costs. This forced traders to close their positions, drawing some emerging market currencies into the turmoil. "Yen-funded carry trades have facilitated significant, dynamic financing around the world," said Powell of BlackRock, who anticipated further volatility as these trades continued to unwind.