The real reasons behind the global plunge: Is the end here for Japan?

Japan’s economy is in the spotlight again, but not for the right reasons. The recent upheaval in the global financial system plus the plummet in crypto markets, can largely be traced back to actions by the Bank of Japan (BoJ). 

Last week, the BoJ decided to jack up interest rates, a move that not only shook the local market but also sent global traders scrambling to close their yen carry trades.

The thing is, in global finance, Japan plays a big role due to its historically low-interest rates, making the yen a favorite for traders looking to maximize returns through the carry trade.

For those unfamiliar, the yen carry trade involves borrowing yen at low-interest rates, converting it into higher-yielding currencies, and investing in more lucrative assets. 

The logic is simple: exploit the interest rate differentials to rake in profits. But when Japan hikes rates, the music stops, and traders rush to unwind these trades, often leading to abrupt market shifts.

The sheer power of the Japanese yen

The yen hasn’t just been a currency; for decades, it’s been a key player in global financing strategies, thanks to Japan’s long-standing policy of near-zero interest rates. 

This scenario began after Japan’s asset price bubble burst in the early ’90s, pushing its economy into what’s dramatically termed the ‘Lost Decades’.

Economic growth sputtered, deflation set in, and both corporate and consumer appetite for investment dwindled.

To fight these economic doldrums, the BoJ slashed rates to rock-bottom levels, so it can stimulate economic activity by making borrowing cheap.

But with traditional monetary tools losing their punch, Japan needed something more aggressive, cueing in Shinzo Abe’s return as Prime Minister in 2012.

Shinzo introduced his now-famous ‘Abenomics’, wielding bold monetary strategies like massive quantitative easing and, later, negative interest rates. 

These policies weren’t about charging borrowers but about pushing real interest rates below inflation to spur spending and investment. This environment fostered the yen’s status as a darling in carry trade operations. 

Traders, sometimes nicknamed ‘Mrs. Watanabe’ after the archetypal Japanese housewife investor, would borrow yen, convert it into assets like Australian dollars or U.S. stocks, and profit from the higher returns. 

This arbitrage extended into the crypto world, where platforms like Compound allowed traders to use similar strategies with cryptocurrencies, further intertwining Japan’s monetary policy with global asset markets.

So, what happened? Why now?

The tranquility of this arrangement was shattered recently when BoJ, under its new governor, Kazuo Ueda, signaled a shift away from negative rates, surprising markets by hinting at rate hikes. 

This wasn’t just a local policy tweak but a response to global economic pressures, notably the U.S.’s rate hike cycle. Traders, skeptical about Japan’s commitment to staving off deflation, reacted sharply. 

The yen, which had been weakening, saw a V-shaped reversal as the market digested these changes. The implications were immediate and harsh.

As yen carry trades unwound, there was a rush to liquidate dollar-denominated assets, leading to significant market corrections.

Cryptocurrencies, often used in these carry strategies, were particularly hard hit, seeing sharp declines. Bitcoin went under $50K for the first time since January.

In the grand scheme of things, while Japan might seem like a follower in the global rate-setting scene, its actions are more coordinated with global monetary policies than they appear.