US stocks quickly recover from August volatility, economists warn: Investors may not be so lucky next time

The economists at the Bank for International Settlements (BIS) have decided to delve into the reasons behind the global financial market crash on August 5. Despite the market turbulence, they found that the market behaved quite robustly. However, investors may not be as lucky next time, and it is almost certain that the next turmoil will come sooner or later. With the weakening of volatility, traders hurriedly plunged back into some leveraged bets that initially caused the big drop. The BIS team stated that ultimately, the fundamental factors of the market did not really change.

According to the BIS bulletin released on Tuesday, the team pointed out, "The factors driving the surge in volatility and significant market fluctuations have not significantly changed. Risk-taking in financial markets remains at a high level."

The BIS team also mentioned that some trades based on low volatility and cheap yen financing were only partially unwound. More extensive yen financing trades involving less liquid assets may unwind more slowly.

However, these economists did not dwell too much on future risks. Instead, they focused on analyzing the specific evolution of the events on August 5. The result was that this report became one of the most comprehensive descriptions of the global market conditions on that day.

While the unwinding of yen carry trades was initially considered the main reason for the sell-off (and indeed it was), it was not the only popular strategy affected in the market deleveraging wave. Over-betting on stocks and options was also impacted.

These strategies had one thing in common: traders increasingly used leverage to chase market momentum, all driven by a period of low volatility. As volatility rose in late July and early August, the market's "fortress" began to crumble.

Data from the prime brokerage business of banks showed that leverage played a significant role in this sell-off. Hedge funds increased their borrowing before the event. As volatility spiked on August 5, clearinghouses demanded more capital from traders to cover risks, triggering a vicious cycle of additional margin call notices.

The BIS team pointed out that currency market arbitrage trades were particularly hard hit. However, the cascading margin call notices also drove an unprecedented intraday surge in stock market implied volatility, with the Chicago Board Options Exchange Volatility Index (VIX) briefly soaring above 65. According to Dow Jones market data, the VIX briefly surged above 65 in pre-market trading in the U.S. market After carefully analyzing all available data, the BIS team was unable to determine the exact scale of the pre-sell yen arbitrage trades. However, they came up with a rough estimate: overall, over $1 trillion may have been used for pre-sell yen arbitrage trades.

This data is based on the loan flows between Japanese banks and foreign borrowers, as well as BIS estimates of currency forwards used by hedge funds. This figure also includes short positions in yen currency futures, although this only accounts for a small portion of the overall figure and does not fully cover the entire range of derivative products that sophisticated traders may use to bet on the yen.

The BIS team pointed out that in addition to professional traders, there is also a large army of retail currency traders in Japan, known as the "Mrs. Watanabe" group, who are also heavily shorting the yen.

The drop in Bitcoin prices on that day indicates that retail traders were also affected by additional margin call notices and may have been forced to close out other positions to cover losses. The BIS team stated that in hindsight, the trigger for the sell-off seemed quite mild, further highlighting the role leverage plays in amplifying collapses.

In fact, this crisis was triggered by two things: on July 31, the Bank of Japan sent a more hawkish rate hike signal than expected. A few days later, data released by the US Department of Labor showed an increase in unemployment rates and a slowdown in the number of new job additions.

According to Dow Jones data, on August 5, the S&P 500 index fell by 3%, marking the largest single-day drop since September 2022. The Japanese Nikkei 225 index fell by over 12%, marking the largest single-day drop since "Black Monday" on October 20, 1987.

The USD/JPY exchange rate fell by 2.8% to 142.54 yen. Since then, the stock market has recovered most of its losses, with the S&P 500 index just one percentage point away from its all-time high closing price set in mid-July as of Wednesday