How the Bank of Japan fuelled the market rout

Japanese equity markets suffered their worst day in decades as part of a global market sell-off fuelled in part by a long-awaited normalisation in Japan’s monetary policy.

The Nikkei 225 lost 12.4 per cent on Monday, its worst day since 1987.

The rout wiped out all the gains made by the Nikkei this year. The Topix also lost 12.2 per cent, marking its worst three-day run since the 1950s.

The sell-off was so strong that the stock market’s trading suspension systems were activated.

Commentators pointed to a wide range of different factors explaining the sell-off, of which one of the most important was last week’s Bank of Japan meeting.

Last Wednesday the Bank of Japan surprised markets by lifting its benchmark interest rate to 0.25 per cent. The central bank also laid out plans to halve its monthly bond purchases, marking a much more hawkish meeting than investors had anticipated.

This is a major shift in the Bank of Japan’s monetary policy. Interest rates in Japan have been below zero since 2016 and have not been above one per cent this millennium.

As Deutsche Bank’s Jim Reid said: “The BoJ is in a hiking cycle for the first time in two decades”.

Hebe Chen, an analyst at IG Markets said the decision would likely keep investors on their toes for some time to come.

“The official start of a full-cycle tightening journey, which has been absent in the Japanese market for three decades, prompts extreme fear-of-the-unknown, potentially keeping both domestic and global traders on edge for a while,” Chen said.

Combined with weak data out from the US, which has raised the likelihood of imminent interest rate cuts, the yen has surged by more than 13 per cent since the end of June.

It was trading at 142.60 on Monday afternoon, having been around 161 just three weeks ago. Brad Bechtel at Jefferies said the surge in the yen was “just mind-boggling” for a major currency.

A stronger yen is a headwind for many of Japan’s largest firms, many of which rely heavily on exports. A stronger currency makes exports less internationally competitive.

“The stronger yen is a headwind for Japan’s stock market in particular…It’s not surprising, therefore, that it’s come under pressure as the currency has turned,” Thomas Mathews, heads of markets, Asia Pacific, at Capital Economics said.

A stronger yen also disrupts the ‘carry trade‘, where investors borrow in a currency with low interest rates in order to invest in higher yielding assets.

BMI, a unit of Fitch Ratings, said that the Bank of Japan’s decision led to “a sharp unwind of the yen carry trade, which added downside pressure on risk assets which were already selling off.”

A correction in tech stocks was another factor driving the sell-off in Japan, with tech firms leading the drop on the Topix. This followed worse than expected results from some of the big US tech giants, with concerns rising that AI might not be all its cracked up to be.