The Japanese Nikkei 225 index plummeted by more than 12% on Monday, marking the largest single-day drop since the “Black Monday” of 1987. The Dow Jones Industrial Average has fallen by about 1,000 points, and the Nasdaq Composite has dropped nearly 4%, with the global market in a state of collapse. Once red-hot but over-leveraged and over-hyped artificial intelligence trading has turned sour, causing technology stocks to be severely battered.
The main cause of the latter is the interruption of large-scale dollar-yen carry trade transactions—investors borrow yen at a low cost and invest in higher-yielding U.S. assets. This can be roughly seen as a large-scale interest rate arbitrage: borrowing at low interest rates and lending at high interest rates.
The Federal Reserve kept interest rates unchanged at its July meeting while strongly hinting at a rate cut in September. Can Friday’s pessimistic jobs report really have such a significant impact on the U.S. economy? It did play a role, but it is hard to explain such a drastic change. The real reason behind this pricing—let alone the calls for emergency rate cuts—is the belief that the Federal Reserve needs to step in and save the market.
This fully illustrates that, in addition to its official responsibilities of price stability and full employment, the Federal Reserve is also considered to have an implicit responsibility for market stability. This hidden third responsibility even has a name: the “Fed put option.”
In the coming weeks and months, it is worth watching the extent to which the Federal Reserve pays attention to market dynamics and the degree to which the market constrains the Federal Reserve to take action. But actions always speak louder than words, and the Federal Reserve’s actions will reveal what its true priorities are.