"The vacationer of doom."

That's the official nickname some friends have pinned on me… as of this week.

In part out of anger, in part amusement.

Their hypothesis:

Every time I unplug and go off-grid for a weekend—like last weekend—chaos ensues. It’s happened, I’m told, too many times to ignore.

(“Last time,” one theorist pointed out, “Trump got shot.”)

As horrifying as that might be if it were true…

The reality? The world spins on its chaotic axis regardless of whether you bought or sold a stock… or my Wi-Fi status.

But pundits do something similar all the time.

Everyone wants to pin major market moves down to one simple thing - a tidy story to make things make sense. Reality is usually more nuanced and complex.

Usually. Not always. 

Today, Sean Ring, our colleague and sharp-witted editor of the Rude Awakening, lays out three more probable causes than my weekend escapes.

To get some help picking apart what really happened…

Read on.

(P.S. I’ll warn you next time before I unplug. Just in case.) 

What (Really) Happened

Last Friday, I was hopeful for a quiet weekend. I wrote this in that edition of the Rude:

We’ve got nonfarm payrolls and the unemployment rate. Barring any massive deviations from the consensus, we should close the week in relative peace.

However, the market had other plans. It was a tumultuous Friday, and today seems to be following suit.

Friday the Bloody: NFP and Unemployment

The First Horseman is unemployment.

The Fed has been monitoring inflation for so long that it has neglected the other important issue: unemployment.

Nonfarm payrolls came in weak for the first time in ages. The market was expecting 185,000 new jobs to be added, but only 114,000 were created. Also, June’s number was revised downward from 206,000 to 179,000.

It’s the lowest level in three months, below the average monthly gain of 215,000 over the prior 12 months, signaling the labor market is cooling off.

The nation’s unemployment rate also jumped to 4.3% from 4.1%.

Now, Jay Powell is under immense pressure to take action. Thanks to the current situation and the factors at play, a significant 50 basis points (0.5%) cut could be possible before the next FOMC meeting. This decision could have far-reaching implications for inflation.

Next, we cross the Pacific.

Japan and the Carry Trade

The Second Horseman is Asian.

In today’s trading in Japan, the Nikkei 225 closed down 12.30% after Friday’s 5.8% drop. After over thirty years of waiting to recapture its all-time high, the Nikkei is down nearly 12,000 points off its peak. The chart below shows it didn’t take long.

Credit: Trading View

After years of negative interest rates, the Bank of Japan's decision to hike rates earlier this year seemed to be a turning point. However, the unexpected hike to 0.25% on August 1st sent shockwaves through the market. 

Suddenly, the yen was crushing the dollar. Notice how similar the charts look.

Credit: Trading View

In FX terms, the USDJPY was rising. The first currency (USD) in the pair is the base currency, and the second currency (JPY) is the variable currency. So when we say, “Dollar-yen is going up,” the dollar is going up, and the yen is going down against each other. It’s never yen-dollar to avoid confusion.

I wrote last week:

If Japanese interest rates keep increasing, the flow may reverse. Japan may start importing capital from other countries.

If that happens, US Treasury bonds would have to offer more of a return to keep investors interested. That means increasing US interest rates and falling US treasury bond prices.

But this will take a lot of time to bleed into the markets.

That last sentence was incorrect, clearly. I can’t believe how quickly this has crushed the markets. Let me explain why.

When you’re in finance, you know the fixed income markets dwarf the equity markets. You need to watch that market, not equity markets, to see signals of impending catastrophe.

In 2007-2008, the fixed income markets fell apart long before the equity markets. Lehman going bankrupt and the stock market capitulating were practically the last events of the Great Financial Crisis of 2008.

So what’s happening now?

Because the Bank of Japan increased rates unexpectedly, USDJPY (and Aussie Yen, in particular) have been crushed. This hurts everyone who has the carry trade on.

The carry trade, a common practice in banking but often unfamiliar to the general investing public, is a crucial element of international finance.

Let’s take a currency with a very low interest rate, like the Japanese yen (JPY), and pair it with the Aussie dollar (AUD), which has a much higher relative interest rate.

Commodity currencies like the AUD tend to have higher interest rates because, among other things, when commodity prices shoot up, the Reserve Bank of Australia, their central bank, needs higher interest rates to quell inflation.

It makes sense:

1. To borrow the yen for practically nothing. The yen is the “funding currency.”
2. Then, convert the yen into Australian dollars, earning a higher interest rate. The AUD is the “target currency.”
3. When the deposit term is up, reconvert the Australian dollars into Japanese yen.

The idea is to capture the interest rate differential. (That’s one reason interest rate differentials matter so much in macroeconomic analysis.)

However, this isn’t a risk-free trade. If the AUDJPY exchange rate falls (the JPY strengthens), you can lose a ton of money on the reconversion. Let me give you an example.

Let’s say today, AUDJPY trades at 109.00. So we’ll borrow JPY 109,000,000 for one year at 0.235%. We then convert those yen into AUD 1,000,000 and deposit that for one year at 4.175%. At the end of the year, we’ll have AUD 1,041,750. We need to convert that back into JPY 109,256,150 to pay off the JPY loan.

Here are a few scenarios:

• If AUDJPY stays at 109.00, we’ll make the initial interest rate differential of AUD 39,400.
• If it's higher than 109.00, we'll make even more money, as converting back to JPY will be cheaper.
• If AUDJPY falls to 104.88, we’ll break even (AUD 1,041,750 x 104.88 = JPY 109,256,150).
• Anything below 104.88, and we’re losing money. The cost of reconversion to pay off the loan eats up all the profit – and more – of the trade.

Where is AUDJPY now? 91.47.

So if we didn’t get out of the trade yet – which we surely would’ve by now – we’d have to convert AUD 1,041,750 at 91.64, giving us only JPY 95,290,435. We’d have to convert another AUD 152,000 or so to make up the difference!

That’s why everyone and his mother is selling AUD, USD, CAD, and any other target currency they used in the carry trade to buy back JPY.

This is what’s called the carry trade unwind. It happens every few years, and a fair few traders get “carried out” (figuratively, on a stretcher).

These losses, combined with the ongoing losses of holding US treasuries, weigh heavily on Wall Street.

The Kamala Factor

The Third Horseman is really a woman.

Finally, I’ve got friends around the world who say, “Your stupid country can’t be serious about Kamala!”

One friend, who runs a hedge fund, wrote, “I think the market is spooked by the fear of a Kamala win.” He continued, “Imagine America’s enemies licking their lips at the prospect of her… The West is f*cked if Kamala gets in.”

This may be a part of what’s going on, as a Harris victory will continue Biden’s policies. And Biden’s policies are Democrat Deep State policies.

If you want to know where that leads domestically, look no further than the riots all over the United Kingdom.

To know where that leads globally, check out Ukraine, Israel, and Taiwan (perhaps soon).

Wrap Up

These aren’t the only things spooking the markets.

The yield curve is now steepening at an alarming speed, initial jobless claims have trended upward, and copper has fallen out of bed.

And although the dollar has been crushed, oil has also moved down.

Crypto and gold have also fallen.

But if Powell cuts in between FOMC meetings, we’ll know the game is up. 

But first, we’ll have a face-ripping rally. That’s why it’s still important to remain calm for now.

Have a great week ahead.