Japan's stock market crash: What happened and why is it dragging the ASX 200 lower

Japan’s benchmark Nikkei 225 stock index is experiencing its worst one-day slump in almost forty years, following the Bank of Japan's decision last week to raise interest rates above zero for the first time since 2007.

The modest 25 basis point interest rate hike has triggered a massive selloff not only in the Japanese stock market but also across global risk assets.

Bitcoin is currently down 13.4% to US$50,470 a piece – a level not seen since February 2024.

While S&P 500 futures are currently down 2.7% and Nasdaq futures have slumped 5.10%.

Explain It Like I'm Five

I've read a lot of articles detailing the events and what's falling. But none have explained why. So here's my simple breakdown.

To understand why the Japanese market and global risk assets are crashing, you need to understand the way the carry trade works.

The quick explanation is – borrow at zero percent interest rates and re-invest in something with returns of greater than zero.

In this case, you borrow the Yen at next to nothing and buy an asset outside of Japan that yields more than zero (aka profit).

The above theory works as long as:

1. Your borrow rate remains zero

2. Your collateral retains its value

3. The asset your purchase with your loan makes money

But all three of these factors are starting to unwind for carry traders.

1. The Bank of Japan raised interest rates last week to "around 0.25%" from the previous range of 0% to 0.1%.

2. Higher interest rates place upward pressure on the Yen's value. This works against carry traders as they have borrowed Yen to buy foreign assets. In more technical terms, they own foreign-currency denominated assets against a Yen-denominated loan. The Yen Currency Index has surged 10% in the past two weeks. So anyone who has borrowed Yen now owes 10% more (at a higher interest rate too).

Japan interest rate chart (Source: TradingEconomics)

Japan Currency Index chart (Source: TradingView)

These factors have caused some traders to sell their assets and repurchase Yen to pay back their loans. But all this demand for the Yen just sends it up even further – which forces more asset selldowns and even more buying pressure against the Yen.

It's a liquidation cascade.

The big question is – Will today mark the end of forced selling or is it just the beginning?

And that's why risk assets across the board are taking a tumble. The Bank of Japan was the piggy bank for the world's assets, an infinite money glitch that investors could use to build massive leverage. And now, all investors are left with is pain.

From an Aussie market perspective, the ASX 200 finished the Monday session down 3.7%. This marks the worst one-day drop since 1 May 2020, where the Index fell 5.0%.

The S&P/ASX Small Ordinaries, which includes all companies in the S&P/ASX 300, excluding those in the S&P/ASX 100, fell 4.48% or the worst one-day drop since 23 March 2020.