For the last three years, it has felt as if markets were waiting for the other shoe to drop. Today, many believe that it has finally done so. Japanese markets crashed on Friday, and even more on Monday; the Topix plummeted 13 percent, a drop not seen since 1987. Global markets followed suit. One might write this off as just another day of volatility. The worry, though, is that this is something much worse: the start of a bear market and a long-feared recession. It’s too soon to tell; markets have been jittery for a long time. But the turmoil does show that we have become over-reliant on monetary policy as the solution to our economic problems.
Since the pandemic, markets had risen—a lot. The S&P 500 was up, just last week, 133 percent from its pandemic lows. Its strength mainly owed to the Magnificent Seven tech stocks. Even if you think that artificial intelligence will be the greatest thing ever to happen to the United States economy, such high valuations this early in the innovation cycle are hard to justify. It also seemed unlikely that inflation would be defeated without a significant slowdown; a soft landing had never happened before.
Despite all these concerns, markets mostly kept climbing, and the economy remained strong, though it never felt completely secure. A recession always seemed in the offing, once something finally broke. Perhaps it has now.
There’s still good cause, though, for staying calm and hopeful. First, a big reason for the drop is the unwinding of the Japanese carry trade. For the last 18 months, to fight inflation, short rates were high in the U.S. but stayed low in Japan. The relatively cheaper Yen created an opportunity for investors to borrow cheaply in Yen and buy higher-yielding Euro and dollar investments. This put even more downward pressure on the Yen, which was good for Japanese companies, as it made exports cheaper, and attracted foreign investors to Japanese stocks.
Now this trade is less enticing. The Japanese central bank recently raised rates (slightly) to deal with inflation, and a bad jobs report in the U.S. has made a September rate cut more likely. All this means that the Yen has started to strengthen, and investors are now abandoning their positions and selling stocks.
On its own, though, this need not mean financial calamity. Japanese companies are still in good shape, and in America GDP, spending, and wage growth remain strong. But the bigger concern is that markets are spooked by any whiff of a possible recession because unemployment, while still low, has now ticked up to 4.3 percent. The end of the carry trade could be the straw that breaks U.S. markets.
Recent precedent suggests such a possibility. Currency moves in 1997 Asia set off a chain of events that nearly brought down U.S. markets and arguably created the conditions for zero rates and bubbles in the future. The environment is unstable and vulnerable to any bad news. It’s no surprise that people are looking for certainty and expect the Fed to deliver it.
Many are already calling the Fed’s decision not to cut rates last week a great error. Wharton’s Jeremy Siegel even called for an emergency 75 basis-point rate cut now, and another in September. This is the sort of action you’d expect only if the U.S. were in the midst of a grave financial crisis. It is not clear how a Fed rate cut last week would have changed things. It certainly would not have maintained the viability of the carry trade—just the opposite, in fact. If the U.S. economy weakens and inflation improves, a rate cut in September might make sense. But if a recession is coming in any case because of some deeper vulnerability, a few rate cuts will not prevent it.
If anything, the current unpredictability shows how aggressive monetary policy, especially in the case of the Japan Central Bank’s keeping rates near zero for a decade and its yield-curve control, can create distortions that cause trouble. It is not the job of monetary policymakers to avoid market volatility. When they try to do so, they only make it worse.
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