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The Summer for markets is normally a quiet period with governments shut down for the holidays and Central Banks loathe to make changes and trading desks thinly staffed. However, this Summer period has been unusually busy, both for Central Banks and geopolitically. It is Central Banks, however, that have sown maximum confusion into the Summer trading vacuum. The Bank of England came out of its General Election purdah and promptly cut interest rates by 0.25%. The US Federal Reserve Bank, as the market expected at that time, held rates at 5.5% but promised to cut at its next meeting in September. Meanwhile, Japan raised interest rates to a still minuscule 0.25%. However, the timing of the latter event, with the benefit of hindsight, was poor. For decades, much of US and global equity trading has been funded by the “Yen Carry Trade.” At a stroke, the actions of these two Central Banks have caused huge volatility, with trading stops triggered through the forced buying of yen and selling of US tech stocks, just when the trading desks are manned by junior staff and computers. At the same time, US economic data seems to be deteriorating, leaving traders fearful that the Fed has done too much monetary tightening and is now too late.

The Yen “Carry Trade”

This chart from Refinitiv shows the dollar/yen exchange rate and the
non-commercial holdings of the yen (inverted to show the trend). It indicates that recently there has been significant buying of the yen and selling of the dollar. This is the unwinding of the “carry trade,” where hedge funds and big investment banks borrow money in Japanese yen at a tiny interest cost, switch the cash raised into dollars (thus selling yen) and then use the borrowed cash to buy rapidly growing US tech stocks. This trade can be hugely volatile, and when events such as the Ukrainian invasion occur, stocks are sold, yen is bought, yen loans are closed and the cash moves back into the safety of the dollar. The sheer scale and speed of the trade often trigger stop losses, thus creating a self-fulfilling process. This seems to have just occurred, with trades being forced by computers into thin summer markets. But as this chart also shows, the trade
direction can easily reverse just as quickly as it sells off.

Sahm Rule

Economists who specialize in employment data have, for many months, been warning that the US economy was in or close to a recession, despite the broad GDP data saying otherwise. The July US Non-Farm Payrolls Data, which shows detailed trends in US employment, was announced at a particularly nervous time for markets. Markets wanted to be reassured that the US economy was on course for a soft landing and that US corporate earnings would continue their recovery. Unfortunately, they didn’t get it. Indeed, the data triggered the previously little-known “Sahm Rule.” This states “that when the moving average of US unemployment rises by 0.5 percentage points compared to a year earlier, a US recession becomes highly likely”. This should not be a surprise. The Inverted Yield Curve, record reduction in the Money Supply, and record Commercial Real Estate defaults, all based on history, indicate that the US should be in a recession. Just because it’s late doesn’t mean that it isn’t going to happen. What is a surprise is that the market participants seem to be surprised! They shouldn’t be; this is all exactly in line with the historic Portfolio Roadmap.

US Recessions usually arrive when the Fed starts to cut Interest Rates

As this chart from BCA shows, the Fed pushes up interest rates to choke off inflation. Markets start to recover when they stop pushing them up. Then the historic pattern is they start to reduce interest rates when there is hard economic data that high rates and a tight money supply have started to be detrimental to the broader economy. We seem to be at that point now. This is not bad news; it is good. However, this crossover phase is often hugely volatile. Often it is characterized by fears of a “double dip recession.” While we have not had a formal US recession, we have had a recession in corporate earnings, especially outside Big Tech. Historically, we always get the “Fed is too late” or the “Fed has done too much” headlines. It seems that is just where we are now, once again virtually exactly in line with historic norms. The market’s narrative was for 0.25% cuts in September and December; remember, the Presidential Election gets in the way during October and November. Maybe now they cut by 0.5% in September? The Fed has loads of room to do so. Inflation is now running at 2.0%; that gives them room to ultimately cut by as much as 2.5% or even 3%!

Markets

We often experience periods of market anxiety in the early stages of a new bull market. Are we in a recession? Is it deep or mild? Have the central banks done too much? Will it end in a Credit Crunch? This is normal and just part of the usual rhyme and rhythm of the markets. The recent events are entirely typical. The price moves might also suggest that a market player has been caught on the wrong side of a highly leveraged trade and is a forced seller. Markets may never know who this is; it can take a while for
such complex trades to be unwound. Historic examples include Long Term Capital Management, Man Financial, and Credit Suisse. The markets have again flip-flopped from the “Goldilocks” scenario to “Economics is Right.” As a reminder, our four broad scenarios are:
1. The Goldilocks i.e. Inflation keeps falling and yet recession is avoided.
2. Economics is right i.e. the US will join the UK and Europe in recession during 2024.
3. The Fed has done too much i.e. a major financial crisis arrives as banks see a wave of defaults.
4. Inflation returns i.e. inflation isn’t beaten and comes back with a vengeance.
If we return to the basic market drivers, i.e. inflation, interest rates and corporate earnings growth, not much has changed despite the recent news. Cuts in interest rates (positive for markets) now seem to be even more likely; US inflation seems settled at 2% and might even go lower; corporate earnings (ex-tech) are still mired in recession-like conditions and can only go up from here; it’s just a matter of timing. So not much has changed, and recent events reinforce the outlook for the broader market. It is the overpriced and possibly slowing tech sector that could have a problem. For “balanced portfolios,” that is just fine. Indeed, the return of bonds to their traditional “plunge-protection” role is very welcome. Importantly, the UK gilt yield curve is now upwardsloping, as it should be, i.e., long-term interest rates are higher than short-dated ones. The US yield curve is also close to uninverting, yet further signs of a return to normal for markets.
In the short term, we have two key events ahead that will dictate the immediate direction for markets. Starting on the 22nd of August, the US Federal Reserve Bank holds its annual symposium at Jackson Hole. This is where it and the other central banks set the tone for the future direction of global monetary policy. With no cut due until September, the comments from Jay Powell will be closely scrutinised. For technology shares, AI chip leader Nvidia will report profits and future sales forecasts on the 28th of
August. This has the potential to move the “Mag 7” shares either way. Markets are nervous, but then again this is nothing new at this point in the cycle.

August 2024