The market volatility we’ve seen over the past week and a half has been astounding. The VXX, an exchange-traded fund that tracks the VIX volatility index, rocketed higher as investors sold equity positions across the board, with more speculative assets such as U.S. tech and cryptocurrencies getting hit the hardest.

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Don't blame recession fears for the market tumult. It's something bigger Back to video

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It all started with some weaker U.S. economic data released on July 31 and Aug. 1. Traders reacted by taking the probability of a 50-basis-point rate cut from the United States Federal Reserve up to 70 per cent from 11 per cent. At the same time, the Bank of Japan announced it was hiking its main interest rate by 25 basis points.

Some have blamed the market volatility on worries of a U.S. recession, but, in reality, this was a massive liquidity squeeze hitting investors who have been borrowing in yen and investing in U.S. assets such as big tech stocks. With the two central banks suddenly going in opposite directions, it caused a portion of the US$4-trillion yen carry trade to quickly unwind.

Don’t kid yourself: the so-called yen carry trade has been a powerful provider of liquidity. For example, we calculate that the yen depreciated by nearly 35 per cent against the U.S. dollar since its January 2021 highs to its mid-July 2024 lows while the Nasdaq had risen nearly 50 per cent over the same period.

At the beginning of the year, pundits were expecting five to seven rate cuts by the Fed and instead went down to two. As a result, from January to mid-July, the yen was down nearly 13 per cent and the Nasdaq was up nearly 25 per cent. However, from mid-July to the Aug. 5 lows, the yen rose 10 per cent and the Nasdaq was down more than 12 per cent as investors were forced to cover their yen shorts.

I noticed a lot of panicking among those in the more speculative assets such as tech, with calls for the Fed to enact an emergency rate cut. Wharton School’s Jeremy Siegel led the charge, calling for as much as a 150-basis-point cut.

I find such a demand astounding, but perhaps after getting bailed out by the Fed many times over the past decade, it is just being made out of habit.

If Fed chair Jerome Powell was more dovish and indicated a 50-basis point cut might be coming in September and/or had cut by 25 basis points at the July 30 meeting, imagine how that would have accelerated the depth and size of the yen carry trade unwinding and the resulting impact on the markets. Then think about what would happen if the Fed took Siegel’s advice.

There are a couple of important takeaways for investors here. Markets don’t always go up, and as Charlie Bilello of Creative Planning LLC has noted, “suffering through drawdowns is the price of admission for long-term investors, without which there would be no reward.” The observation is especially true for younger investors who are early in their savings journey and can take advantage of price sales in the market by averaging in.

For older investors, corrections such as these are a fantastic gut check on your ability to emotionally withstand corrections to your portfolio, especially if it is important for you to keep pace with the hottest market segments.

We have taken a different approach by focusing on risk-managed returns and implementing downside protection on well over three-quarters of our positions. This means that while we will not fully track high-growth segments of the market, we also won’t experience a similar move to the downside.

For example, while many of these segments corrected by double digits during the worst of the selling, we calculate that our risk-managed balanced fund fell only 0.3 per cent, giving back some of the 8.1 per cent gained to the end of July.

That does not mean we were sitting idle, as our contrarian nature also had us adding to those segments of the market that have nothing to do with the yen unwind, but suffered losses even deeper than those of the tech sector. Those sectors included Canadian oil and gas, Canadian utilities and banks, which will benefit from accelerated rate cuts.

The good news in the end was that the Bank of Japan caved last Wednesday and indicated it would not hike interest rates again as long as markets remained unstable. That decision resulted in a steep recovery in global risk along with a rebound in those segments that sold off the hardest.

The lesson in all this market drama is that there is value in being able to sleep at night, especially if it means not having to stay up to follow Japanese equity and currency markets.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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