Nikkei rebounds after suffering Black Monday style collapse

Japan's Nikkei index suffered its most catastrophic single-day decline since the infamous Black Monday of 1987, plunging as much as 12.4% on Monday, 5th of August. Today, the Japanese index is bouncing back, erasing almost all of yesterday’s fall.

This unprecedented loss that followed a few red days wiped out all of the index’s year-to-date gains, plunging it into negative territory after an almost 30% gain in 2023. As of Tuesday, 6 August, the Nikkei is up more than 1% over the year.

The Japanese Yen (JPY), meanwhile, surged to its highest level against the American Dollar (USD) since December 2023, exacerbating concerns about the impact on Japan's export-driven economy, trading at around 145 at the time of writing, after falling to the lowest of 141.67 yesterday.

Daily Nikkei 225 & USD/JPY Charts - Source: Online Trading Platform from the Regulated Broker ActivTrades

Traders pinpointed the Bank of Japan's surprise interest rate hike last week as the primary catalyst for the Japanese market meltdown. The stronger JPY, a direct consequence of the rate increase, can somewhat erode the competitiveness of Japanese exporters, threatening to derail the nation's fragile economic recovery. Remember that both assets are negatively correlated, which means that when the Japanese Yen goes up, the Nikkei tends to go down. Additionally, the deepening worries of the US tech sector and broader economic uncertainties have compounded Nikkei's woes.

Bank of Japan's recent rate hike potential impact on Japan's economic recovery

Japan's economic landscape has been marked by significant challenges over the past few decades. The country endured a prolonged period of economic stagnation known as the "Lost Decade" following the collapse of its asset price bubble in the 1990s.

To combat deflation and stimulate growth, Japan adopted an ultra-loose monetary policy in 2016, including negative interest rates. This policy encouraged banks to lend rather than hoard cash, thereby boosting economic activity. However, this approach failed to ignite sustained growth and led to a significant depreciation of the Yen.

The Yen's weakness was exacerbated by the global trend of rising interest rates. As other major economies tightened monetary policy to combat inflation with rapid rate hikes, investors sought higher returns by shifting their funds away from the low-yielding Yen and into assets denominated in stronger currencies, such as the American Dollar, the Australian Dollar or the British Pound.

This dynamic fueled the popular currency carry trade strategy, where investors borrowed cheaply in Yen to invest in higher-yielding assets, further amplifying downward pressure on the Yen.

The Yen's persistent weakness has posed challenges for Japan's export-oriented economy, as it eroded the competitiveness of Japanese goods in global markets.

To address these challenges and stabilise its economy, the Bank of Japan made another historic shift in monetary policy in July 2024. The central bank raised interest rates to “around 0.25%”, mostly aiming to strengthen the Yen, in addition to curbing inflation, and foster sustainable economic growth. This marked the second rate hike in 17 years, as Japan gradually normalised its monetary stance.

The Bank of Japan's surprise rate hike has sent waves through the market, with far-reaching implications for the Japanese economy.

A stronger Yen, a direct consequence of the rate hike, poses a formidable challenge to Japan's export-oriented economy. Furthermore, the rate hike could dampen domestic consumption. Higher borrowing costs may discourage spending on big-ticket items, such as housing and automobiles, potentially slowing down economic growth.

US growth concerns and tech collapse might also add fuel to the sell-off

Increasing concerns about the state of the economy are building and having an impact on the global markets, as seen by the recent increase in the VIX index. This indicates that investors have grown more anxious about the possibility of a slowdown in economic activity, as the fear index has been nearing its greatest level since the Covid-19 outbreak emerged.

According to the most recent statistics on employment in the United States, the unemployment rate increased to 4.3%, which marks the greatest level since October 2021. This has damped investor confidence, which has been further undermined as a result of a combination of factors, including cooling economic indicators in the United States, the hawkish stance of the Federal Reserve (Fed) and poor earnings reports from the technology industry.

The Fed's unrelenting hawkish posture, which was exemplified by its decision to keep interest rates within a range of between 5.25% and 5.5% last week, stands in sharp contrast to the accommodating monetary policies that have been enacted by other major central banks.

Over the course of this year, the European Central Bank (ECB), the Bank of England (BoE), and the Swiss National Bank (SNB) have all begun the process of lowering their interest rates. Despite the fact that market forecasts indicate that the Federal Reserve will reduce interest rates in September, there are rising fears that this move may prove to be insufficient and too late to prevent a downturn in the economy.

Additionally, investors are looking for refuge in safe-haven assets such as the Japanese yen, while simultaneously selling riskier growth shares, notably those in the technology industry.

The NASDAQ Composite has plummeted nearly 10% in the past three weeks, marking its steepest decline since September 2022. Yesterday, the tech-laden index tumbled as much as 5.30%, as investor enthusiasm for artificial intelligence wanes and disappointing earnings reports from tech giants like Amazon, Nvidia, and Microsoft weigh heavily on the market.

What's next for the Nikkei 225 Index?

Investors will closely monitor economic indicators from China and other Asian nations, as well as the upcoming monetary policy decisions of the Reserve Bank of Australia (RBA) and any commentary from the Bank of Japan (BoJ). These factors will be important in determining the future trajectory of the Nikkei index.