A 20% plunge in three days! UBS warns that the sell-off in Japanese stocks will continue, now entering what is tantamount to "catching a falling knife" situation

Yen's impact triggers a frenzy of selling in the stock market, how long can the Japanese stock market hold on?

On Monday, August 5th, Japanese stocks plunged, leading the decline in the Asia-Pacific stock market. By the close, the Nikkei 225 index fell by over 11%, marking the largest drop in history, with a cumulative drop of nearly 20% in three days; the TOPIX index closed down 12%, marking the largest single-day drop since 1987, triggering the circuit breaker multiple times during the trading session.

Based on the closing price, the Nikkei 225 index has fallen 26% from its July high, while the TOPIX index has dropped 24% from its record level, both entering a technical bear market territory.

UBS Global Wealth Management's Chief Investment Officer for the region, Kelvin Tay, commented that the only reason for the strong rise in Japanese stocks over the past two years has been the very weak yen:

"Once the situation reverses, you have to exit in a timely manner. I think investors have withdrawn because of this."

In Tay's view, entering the Japanese market at this time is like "catching a falling knife."

Due to the unexpected rate hike by the Bank of Japan last Wednesday, the Fed signaling a potential rate cut starting in September, expectations of a narrowing US-Japan interest rate spread, the yen surged in response, reaching its highest level since January, putting pressure on Japanese export companies and subsequently weighing on the domestic stock market.

According to the statement by BOJ Governor Haruhiko Kuroda, the possibility of the central bank raising rates again in the future is not ruled out.

Strong Yen as the Catalyst?

Tay stated that the strength of the yen is a "barometer" for judging the performance of Japanese stocks, and it was also the main driving force behind the previous rise in Japanese stocks. With the BOJ announcing a rate hike, the return of a strong yen has become the catalyst for the stock market crash.

Wall Street CN previously mentioned that due to the Bank of Japan maintaining interest rates at low levels for a long time, the yen is often seen as one of the most attractive currencies for arbitrage trading.

For example, using the central bank's benchmark interest rate as a guide, before the BOJ announced a rate hike, investors could borrow yen at 0% interest and invest the funds in the US to earn 5.25% interest.

With the BOJ raising rates to 0.25%, bringing the highest policy rate since 2008, the attractiveness of arbitrage trading significantly decreased, leading investors to convert their US dollar assets back to yen, increasing market demand for yen and thus strengthening the yen.

Tay expects that with larger inflows of yen from Japanese life insurers and the Government Pension Investment Fund (GPIF), the USD/JPY may further decline to the 135 level:

"Unfortunately, Japanese stocks will still face greater pressure."

As of the time of writing, USD/JPY has fallen to 142.29, with an intraday decline of nearly 3%

Intensified Selling Pressure from Margin Trading

Another factor accelerating the decline in Japanese stocks is the unwinding of large-scale margin trading positions.

Amid strong bullish sentiment, retail investors had accumulated the largest margin buying positions since 2006, exceeding $30 billion by late July. However, as Japanese stocks continued to fall below expectations, these investors may have to unwind their positions.

Margin buyers typically borrow money from brokers to purchase stocks, often using high leverage. If the market weakens, investors may need to unwind their positions, leading to increased selling pressure.

Takatoshi Itoshima, a strategist at Pictet Asset Management, commented:

"Retail investors seem to be forced to sell."

"While we may be approaching a peak in selling pressure in the short term, I cannot be certain."

Masahiro Ichikawa, Chief Strategist at Sumitomo Mitsui DS Asset, stated:

"People without long-term investment experience may not have gone through such a market collapse, so the impact could be significant."

"I believe that after such a significant decline, the market will need more time to stabilize."