Global markets are off to a terrible start this week, and Japan is partly to blame

• Global markets are off to a terrible start to the week.
• Japan's rate hike sent Asian markets crashing on Monday. US stock futures are also down.
• Investors are fretting about Japan's interest-rate hike and US economic outlook.

Global markets are off to a terrible start to the week.

Stock markets are crashing across Asia after Japan's interest-rate hike last week contributed to a selloff that got worse and worse.

Japan's benchmark Nikkei 225 index crashed by as much as 13% by 3 p.m. local time. Meanwhile, South Korea's Kospi was 9% lower after a trading halt was triggered.

Taiwan's Taiex closed 8.4% lower in its worst day on record.

Australia's ASX 200 was down 4%.

India's Sensex was 3% lower, while the Nifty 50 was down 2.8%.

"We haven't seen a day of carnage like this, really, since the COVID selloff back in February, March 2020, " Tony Sycamore, an analyst at IG Australia, told Bloomberg TV.

Hong Kong's Hang Seng Index fell as much as 2.8%, and China's CSI 300 was 0.9% lower. The Chinese stock markets have been under pressure this year due to the country's economic troubles.

Investors are also on edge before the US markets open later in the global day. S&P 500 futures were down 2.8% at 1:28 a.m. ET, while Dow Jones Industrial Average futures were 1.2% lower. Nasdaq 100 futures were down 5.4%.

Bitcoin tanked 17% over the past 24 hours.

The negativity in US stocks ahead of the week's opening came after a recent selloff in tech stocks as euphoria over artificial intelligence fizzled, with investors questioning when they would be seeing returns.

A weak July jobs report from the US added to investor gloom, sparking a selloff in US stocks on Friday, just days after the Federal Reserve kept interest rates steady again.

But it's not just the US economy and the Fed that is weighing on the markets. It's also about Japan's interest-rate hike last Wednesday, which IG's Sycamore told Bloomberg TV was "the straw that broke the camel's back."

Global carry trade unwinding

The Bank of Japan raised its interest rate from between 0% and 0.1% to 0.25% on Wednesday — the highest level in 15 years.

Even though it appears tiny, it matters because the Japanese yen has been the focus of carry trade, where traders profit from a divergence in interest rates across the world. Since the turnover in global foreign exchange markets is massive — it reached a record $7.5 trillion per day in April 2022, according to a triennial survey — the fallout can be huge.

Japan kept interest rates ultra-low for decades following the implosion of an asset bubble in the 1990s that contributed to persistent deflation. It continued holding rates low after the pandemic, in contrast to other major central banks that started hiking them.

This created a divergence in monetary policy that impacted the Japanese yen, which sank to a near four-decade-low against the strong US dollar last month.

This divergence helped carry trade, which, as ING analysts explained on Monday, has been a dominant successful investment strategy this year.

It involves "borrowing cheaply in yen — on the expectation that the yen will continue to fall — and investing in some high-yielding currency or asset preferably backed by a strong macro argument," the ING analysts added.

However, this strategy is now hit with a hitch, as the BOJ's rate hike last week sent the yen up — it's 7.8% higher over the last five trading days and is 1.3% lower against the dollar so far this year.

On Monday, the yen rose as much as as much as 3.3% to 141.70 per dollar, a level last seen in January.

The BOJ's rate hike has also fanned further risk-off sentiment in global stock markets.

"The unwinding of yen shorts is undoubtedly contributing to the global risk-off environment," wrote ING analysts in a separate July 25 note.

There are still be choppy waters ahead, particularly for risk assets, warned Vishnu Varathan, Mizuho Bank's chief economist of Asia excluding Japan on Friday.

"The dark clouds of adverse feedback loop between 'carry' liquidation and 'risk off' contagion cannot be ignored," he added.