Don't blame recession fears for the market tumult. It's something bigger

financialpost.com:

The market volatility we’ve seen over the past week and a half has been astounding. The VXX, an exchange-traded fund that tracks the VIX volatility index, rocketed higher as investors sold equity positions across the board, with more speculative assets such as U.S. tech and cryptocurrencies getting hit the hardest.

It all started with some weaker U.S. economic data released on July 31 and Aug. 1. Traders reacted by taking the probability of a 50-basis-point rate cut from the United States Federal Reserve up to 70 per cent from 11 per cent. At the same time, the Bank of Japan announced it was hiking its main interest rate by 25 basis points.

Some have blamed the market volatility on worries of a U.S. recession, but, in reality, this was a massive liquidity squeeze hitting investors who have been borrowing in yen and investing in U.S. assets such as big tech stocks. With the two central banks suddenly going in opposite directions, it caused a portion of the US$4-trillion yen carry trade to quickly unwind.

Don’t kid yourself: the so-called yen carry trade has been a powerful provider of liquidity. For example, we calculate that the yen depreciated by nearly 35 per cent against the U.S. dollar since its January 2021 highs to its mid-July 2024 lows while the Nasdaq had risen nearly 50 per cent over the same period.

At the beginning of the year, pundits were expecting five to seven rate cuts by the Fed and instead went down to two. As a result, from January to mid-July, the yen was down nearly 13 per cent and the Nasdaq was up nearly 25 per cent. However, from mid-July to the Aug. 5 lows, the yen rose 10 per cent and the Nasdaq was down more than 12 per cent as investors were forced to cover their yen shorts.

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