The upward trend that started at the end of 2022 continued until mid-July. The S&P 500 index, which tracks the largest US companies, reached its all-time high of 5,669 points on 16 July. Japan’s Nikkei 225 index, which on 22 February this year surpassed its peak mark of 34 years ago (38,915.87), reached 42,426.77 points on 11 July.

Investors are so used to the constant rise of stock prices and new peaks that these records hardly impressed anyone. In the second half of July, the markets gave back a little of their gains, which made the monthly changes in the largest stock indices relatively modest.

However, on 31 July, a rare monetary policy decision was made in Japan, the impact of which may be greater and longer-lasting than interest rate adjustments by the US Federal Reserve or the European Central Bank. Namely, the Bank of Japan raised its key interest rate to 0.25% in yen.

Considering Japan’s inflation rate was 2.8% in June and had exceeded 2% for some time, the move was logical and even long-awaited. On the other hand, against Japan’s monetary policy, the decision was very extraordinary and, in the historical context, even terrifying as all economic and financial crises in the world, since 1990, have coincided with the Bank of Japan raising of interest rates.

In the early 1990s, the Bank of Japan burst the Japanese real estate and stock market bubble by raising interest rates, and in 1997 the rise in its interest rates coincided with the Asian financial crisis. When the Bank of Japan raised interest rates again three years later, the US internet stock bubble burst. During the 2006 interest rate hike, the first signs of concern appeared in the US real estate market and later led to a global financial crisis.

Now that the Bank of Japan raised its interest rate by 25 basis points on 31 July, the financial market ‘fear index’ VIX leapt to an exceptionally high level in the following days. A financial analyst jokingly commented on this on the X platform: “According to the VIX, the worst market events of our lives were the 2008 financial crisis, COVID, and the Bank of Japan raising interest rates by a quarter percentage point.”

Source: X

Because interest rates have been kept very low for a very long time, the Japanese yen has been the borrowing currency for speculative investors. They invest this money in other markets and in other currencies that offer higher returns. For example, if a loan is taken in yen, but the money is invested in the US technology sector, then the yen must be exchanged for dollars.

This investment strategy is called ‘carry trade’. It is possible to make a profit just by borrowing in yen at a low interest rate and investing it in dollars but at higher interest rates. This can be done if the exchange rate does not move in an unfavourable direction. If a huge number of investors borrow in yen and then sell the yen and buy dollars, the yen will depreciate against the dollar.

Investors have been exploiting this strategy for a very long time, and this has been the reason for the yen’s decline. However, now that the Bank of Japan is starting to raise its interest rates at a time when both the US and Europe are cutting theirs, carry trade will become less profitable. This means that the trend of taking money out of Japan may reverse: many high-yielding positions taken in other currencies will be sold to buy yen and repay the loans previously taken out in yen.

Although the Japanese government has a staggering debt burden, Japanese businesses and households are big savers. That’s why Japan is the world’s largest net exporter of capital.

International investment position of the ten largest economies (EUR billion) in 2023. Source: IMF, ECB and Eurostat

The yen carry trade has been going on for a very long time and on a very large scale. If it starts to close, it will mean massive reverse capital flows over a long period of time, affecting a great many capital markets, both large and small.

The investment strategy of LHV pension funds is primarily based on fundamental analysis, and we tend to refrain from speculative investments. However, large trends and sudden changes in international markets inevitably affect everyone. Still, companies that can grow sales year after year and earn decent profits will be less affected by this than companies whose high value is based solely on new future trends.

Thanks to this, LHV pension funds are currently positioned solidly and conservatively in the markets. We don’t bet too much on trends and have spread risks across a wide variety of asset classes.