The root of "Black Monday": the moment of reckoning for loose policies

Global stock markets have been on a relay-style decline since last Friday, with the Japanese stock market suffering the most severe blow. The Nikkei 225 index plummeted by 12.4% on Monday, marking the largest single-day drop since the "Black Monday" of 1987. Stock markets in other Asian, European, and American countries have also followed suit.

Some analysts point out that the global stock market decline not only represents a correction of overvalued tech stocks but may also signal the moment of reckoning for the loose monetary policies of the United States and Japan over the past decade. The speed and intensity of this reckoning remain unknown.

Chain Reaction Triggered by Japan's Rate Hike

The direct cause of the sharp drop in the Japanese stock market is the long-awaited reversal of monetary policy and the yen exchange rate.

The Bank of Japan unexpectedly announced a rate hike to 0.25% last Wednesday and outlined a timetable for gradually reducing quantitative easing. BOJ Governor Haruhiko Kuroda made a very clear statement on the exchange rate issue: part of the reason for the rate hike is to curb the depreciation of the yen.

Some analysts point out that after nearly 17 years of ultra-loose monetary policy in Japan, this year's consecutive aggressive rate hikes have triggered a foreseeable and necessary repricing of risks.

In particular, the significant interest rate differential between long-term low Japanese rates and US rates led to a sharp depreciation of the yen in the first half of this year. However, with the BOJ's aggressive rate hikes and the Fed preparing to cut rates, this interest rate differential is currently narrowing.

The continued weakening of the yen has attracted foreign investors to buy Japanese stocks. According to economist Jesper Koll, as of March, nearly one-third of Japanese stock investors are foreign investors in terms of value. The depreciation of the yen has also boosted the expected profits of Japanese companies priced in yen.

However, Kuroda stated at the rate meeting that the era of ultra-low interest rates has come to an end.

In this recent round of sharp declines that began last week, the Japanese stock market at one point wiped out all its gains for the year, while the yen recovered all its losses during the same period, which is no coincidence. After falling to around 162 last month, the yen surged to 144 yen on Monday.

In a report this week, JP Morgan pointed out that the selling pressure in the Japanese stock market was mainly driven by foreign investors.

The next trigger could be: Japanese investors withdrawing from overseas markets. The previous low interest rates and a weak yen had driven a large amount of carry trades, borrowing cheap yen and investing in higher-yielding dollar assets. The appreciation of the yen indicates a reversal in the carry trade environment, and foreign capital markets, including US Treasuries, need to prepare for the withdrawal of Japanese capital.

The Long-Term Loose Rate Environment of the Fed Will Also Face Reckoning

So, what about investors' concerns about a US economic recession?

These concerns are real. Wall Street criticized the Fed for not cutting rates at the latest meeting, followed by a poor US non-farm payroll report, triggering the Samson rule, implying an impending US economic recession. Although it also led to a sharp drop in US stocks, this panic even spread to European and Asia-Pacific stock markets.

Some analysts point out that although the weak July employment report in the US did not show an unemployment rate at the level of an economic recession, it is difficult to judge now what difference it would make if the Fed cuts rates in July instead of SeptemberThe call for the Federal Reserve to rescue the market reflects Wall Street's strong dependence on the Federal Reserve.

Once the U.S. Congress reaches a deadlock on economic policies, they often only agree on increasing government spending. Since the 2008 financial crisis, the U.S. economy has largely relied on expanding government spending and loose monetary policies to sustain itself. However, a long-term loose interest rate environment is never free and cannot last forever, eventually leading to a reckoning.

This is one of the reasons why the Federal Reserve has to raise interest rates to curb inflation, and now part of this reckoning has come with a sharp drop in the stock market