Dead Cat Bounce
Why the stock market rally won't last
Investors got a taste of something sour this week—market action no one’s seen since the COVID lows of March 2020. As the Asian markets opened Sunday night, selling immediately inundated the stock, forex, and bond exchanges across the Eastern Pacific. The TOPIX, Nikkei, and other indices fell like a stone from the sky. Before long, investors were looking at double-digit percentage losses across multiple asset classes. Japanese banks, industrials, and cryptos fared the worst, as the Yen whipsawed stronger in a rapid revaluation.
American index futures held steady with only slighter under three percent losses until early Monday morning when all hell broke loose. Nasdaq futures hit the low of the day before the opening bell, down more than 1,300 points from Friday’s close. The DJIA and S&P weren’t much better off. Equities closed well off the lows, though Monday’s chaos left many investors shaking and wondering what’s next. The VIX showed it.
Tuesday was eerily quiet, inviting speculation over the events of the previous day. Many analysts attributed Monday’s market crash to the shocking jobs report and renewed fears of recession. Twitter pundits took hold and branded the event as the ‘KAMALA KRASH’. Not so. As much as arm-chair traders and politicos wish the explanation were that simple, it never is and isn’t this time either.
What traders and those actually “in-the-know” think we know, is that the surprise rate hike last week from the Bank of Japan triggered a massive imbalance in the forex markets and popped the bubble held up by the Yen carry trade. Allow me to explain. As Western central banks raised rates to combat four-decade high inflation, the Bank of Japan took the opposite approach, maintaining interest rates near record lows throughout the entire Federal Reserve, ECB, and BOE hiking cycle. This made it highly profitable to borrow yen, which was cheap and getting cheaper. Investors then sold the borrowed yen for dollars and bought dollar denominated assets. The bet is simple: if the yen keeps getting weaker, and the dollar stronger, then when Japanese investors sell their dollars and buy back in yen, they’ll turn a profit.
That is, until last Wednesday, when the BoJ announced their rate increase. Meanwhile, the markets anticipate, and the Fed has said, that the Federal Reserve will be easing policy by lowering rates beginning at the September meeting. This means the yen carry trade described above was no longer so profitable, and that investors anticipate it to be even less profitable, as the BoJ and the Fed continue to march opposite one-another down their respective policy paths. Investors knew they had to unwind all their positions or face more losses in the future. That’s what they did.
With Tuesday having been so quiet, commentators and traders are speculating that the unwind is over. All is well. Let’s move on. This couldn’t be further from the truth. Markets proved that today, as Tuesday’s gains were more than erased, and losses are growing larger this evening in the futures markets.
Panic and uncertainty have totally shaken investor confidence. Experienced traders know events like this don’t go quietly into that dark night. Someone somewhere, and likely someone big, could have easily blown up from Monday’s massive market dislocations. In fact, if there aren’t at least a few large money managers, banks, or pension funds teetering, I’d be surprised. Many are licking their chops. But it’s the big systemic ones, with wounds that won’t heal on their own, who will come back to the market now to sell. When this happens, and it will be soon, we will see the next leg down. And markets won’t be so calm anymore.