Crypto, Stock Markets Shudder as Recession Fears Intensify—How Did We Get Here?

As financial markets awoke to massive, cascading hits across the globe on Monday, multiple analysts used the same analogy to describe the downturn: a perfect storm. 

Analysts principally point to developments in the United States and Japan, which have coalesced to create a troubling scenario and raised fears of a global recession, triggering sell-offs across both traditional and crypto markets.

British financial services firm AJ Bell attributed the slump to two main factors: the swift decline of American markets after years of better-than expected performance, and the Bank of Japan’s deployment of higher interest rates last week to protect the long-slumping yen from abuse as an easy source of liquidity for market makers. 

In a note on Monday, AJ Bell Investment Director Russ Mould pointed to several signals that the U.S. economy is slowing, including rising unemployment, a housing market in disarray, and weak performance in the country’s manufacturing sector. 

U.S. slowdown

On Friday, the U.S. government revealed that the nation’s unemployment rate climbed to 4.3% in July, with only 114,000 jobs added last month—the weakest showing for the U.S. economy since December 2020. The country’s housing market, meanwhile, appears paralyzed by the combination of increased supply, soaring prices, lessened demand, and dwindling investment; while economic activity in its manufacturing contracted in July for the fourth consecutive month.

What’s more, those potentially troubling indicators appear to have caught financial traders and institutions totally by surprise.

“A U.S. slowdown is not priced in at all,” Mould wrote. “If anything, markets were more concerned about it overheating earlier this year.”

While signs do not necessarily indicate that the U.S. is doomed to fall into a recession, such an outcome is more than possible even if the U.S. government takes swift action, the analyst said. 

“Those with long memories will remember how frantic rate cuts in 2000-02 and 2007-08 failed to stave off a bear market in stocks,” he continued. “Because the economy tipped over and corporate earnings fell far faster than the headline cost of money.”

Yen carry trade

Concerns about such risks were exacerbated by developments last week in Japan, where the country’s central bank opted to raise interest rates for only the second time in 17 years, in a bid to bolster the struggling yen against rampant borrowing by market makers. 

The gambit appeared to work when the yen surged on Monday to levels not seen since the start of the year. But that same progress has sent ripples of panic across the globe, as investors struggle to maintain positions in what are known as carry trades, in which they borrow yen to buy up higher-yield currencies like the U.S. dollar. 

“With the yen strengthening, the cost of maintaining these trades has skyrocketed, leading to a rapid sell-off in U.S. equities as investors scramble to repay yen-denominated debts,” Nigel Green, the founder and CEO of financial advisor deVere, said in a note on Monday.

Such rapid sell-offs can then lead to cascading liquidations, not unlike those seen in the crypto market over the last several years, exacerbating the slump. As traders exit positions into yen, the price of yen against the dollar increases, thereby putting traders engaged in carry trade strategies in an even worse position—and further increasing the sale of U.S. equities and other risk assets to pay off their debts.

“Right now, the main catalyst of this selloff isn’t a pandemic-related global shutdown, it is the elimination of the yen carry trade, which Japanese central bankers poured cold water on by raising interest rates,” Cube.Exchange CEO Bartosz Lipinski told Decrypt. 

“Previously, one could borrow yen virtually for free and use it to express opinions in the market across a variety of assets. Now yen has become more costly, and there is the double-whammy of not only making this strategy unattractive but traders now also liquidating to pay off yen-denominated loans,” Lipinski said.

Early Monday, Asian stock markets plummeted as developments in America and Japan commingled to create a financial maelstrom. American markets fell sharply when they opened hours later.

“This shift highlights the vulnerability of U.S. markets to changes in global financial dynamics,” deVere’s Nigel Green said. “The drop in U.S. stock prices as the yen strengthens is a clear indicator of how interconnected global economies have become.”

The same can be said for the crypto market, which—once valued for its independence from traditional finance—sank on Monday along with the rest of the global economy. By Monday morning, Bitcoin breached $50,000, Ethereum crashed 24%, liquidations of crypto-related positions exceeded $1 billion in 24 hours, and the crypto market’s collective value fell below $2 trillion for the first time since the bull market kicked off earlier this year.