The Japanese stock market is currently witnessing one of its most severe downturns in recent history, marked by a staggering plunge in the Nikkei 225 index, which dropped by an astonishing 7%. This rapid decline triggered a circuit breaker on the Tokyo Stock Exchange, marking the largest single-day drop in eight years and sending shockwaves across the region as the Korean stock market also experienced a plummet of more than 6%. This dramatic sequence of events is not just an isolated incident; it represents the third consecutive day of significant losses for the Nikkei index, culminating in an overall decline of nearly 15% over three daysThe index has now fallen over 20% from its peak in July, which had set a historical record.

But while Japan endures this market frenzy, neighboring South Korea is feeling the effects, tooThe Korea Composite Stock Price Index had already plunged by 3.67% in the previous trading session and followed up with an even sharper decline to start today

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Many analysts are left to ponder the reasons behind this sharp downturn, especially considering that the roots of the current market turmoil can be traced back to developments in the United States, where the economy is also showing signs of slowing down.

One of the prevailing theories attributing the market chaos lies in Japan’s recent monetary policy changesIn a significant decision last week, the Bank of Japan elected to raise its policy interest rate from the previous range of 0% to 0.1% to a new level of 0.25%. This marks the first interest rate hike since the lifting of its negative interest rate policy earlier this year in MarchAdditionally, the Japanese central bank announced plans to taper its bond-buying program, suggesting quarterly reductions of approximately 400 billion yen until the first quarter of 2026, leading to a monthly purchasing cap of 3 trillion yenSuch actions have undoubtedly sent ripples through the financial markets akin to a bombshell.

The pivotal question arises: what is driving the volatility in Japan’s stock market? There are several contributing factors worth considering.

First and foremost is the concept of arbitrage reversal

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For a long time, global investors have favored engaging in yen-based arbitrage, borrowing yen at low interest rates to invest in higher returns elsewhere, a trend that has intensified during the recent U.Srate hike cycleHowever, the sudden and rapid appreciation of the yen upends this strategy, leaving arbitrageurs scrambling to liquidate their yen positionsThe thriving Japanese stock market suddenly presents itself as a prime avenue for these investors looking to cash in their profits quickly, thereby inducing further downward pressure on stock prices.

The second factor pertains to a reversal in economic expectationsThe Japanese economy has observed relatively positive growth over the past year, largely fueled by the depreciation of the yen, which has heightened export competitivenessThe upward momentum in the stock market has similarly correlated with this depreciation, as the conversion of dollar profits into yen results in inflated profits for Japanese companies

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For instance, Toyota is expected to report a nearly doubling of profits year-on-year in 2023, benefitting substantially from favorable exchange ratesHowever, the recent strength of the yen poses threats to export figures and profitability for cCompanies such as Toyota, as rising currency values make their products more expensive abroad.

Thirdly, the anticipations for the high-tech sector have also begun to show signs of weakening due to prevailing recession fears in the U.SThe Philadelphia Semiconductor Index, for instance, has seen some of the worst losses amidst these fearsMoreover, the recent rise of the Korean and Japanese stock markets has, to an extent, been propped up by optimistic projections surrounding semiconductors, in which Japan excels in supply materials while South Korea specializes in memory chipsEssentially, both regions act as downstream entities reliant on the performance of the upstream American technology sector; when American markets flounder, there’s a ripple effect felt across Japan and South Korea, adversely impacting their market sentiments.

Finally, there's the notion of ‘high places are cold'. Prior to this downturn, both Japan and South Korea's stock markets were enjoying a robust phase; the Nikkei had surged from under 30,000 to over 40,000. Given that Japan’s economy is already shaky, the significant rise in stock prices was largely perceived as an unsustainable bubble fostered by the devaluation of the yen