14 August 2024
Trouble began on Friday, August 2, when the US government released a worse-than-expected, but not terribly bad, employment report. That led some investors to believe that the Federal Reserve had waited too long to start cutting interest rates and that the risk of recession was now significant.
That led to declining equity prices, lower bond yields, and a lower-valued US dollar. But that was not the only thing happening in financial markets. Other factors contributed to much more significant turmoil the following Monday, August 5. US and global equities fell sharply, oil prices fell, the dollar fell 2.7% against the yen, and the US 10-year Treasury bond yield fell to a one-year low. Should we be worried? Not necessarily.
First, the jobs numbers showed a slowdown in job growth, not a catastrophe. Some analysts pointed to the fact that the so-called Sahm Rule had been triggered, due to a sharp rise in the unemployment rate. The Sahm Rule is very simply based on how fast the unemployment rate is rising. Economist Claudia Sahm found that, in the past when the three-month average of the unemployment rate exceeded the lowest rate of the last 12 months by more than 0.5 percentage points, it meant that a recession had begun. Yet the rule is not a law of physics. Rather, it is a consistent pattern. Yet Dr. Sahm herself said that, given the unusual economic trends of the post-pandemic period, a triggering of her rule might simply be a false positive.
Second, on a day when investors were evidently panicking about the state of the US economy, the Institute of Supply Management (ISM) reported that its purchasing manager’s index (PMI) for US services increased from 48.8 in June to 51.4 in July, indicating growing activity. PMIs are meant to be forward-looking indicators. Thus, the rise in the PMI is a sign of a likely rebound in services activity.
Third, it was reported that, on August 5, investors were having difficulty gaining access to online trading platforms operated by brokerage firms. This suggests that fearful investors were struggling to unwind their positions. Selloffs beget selloffs. This has happened before. Generally, those who sat on their assets ultimately profited. This also reminds us that asset markets tend to overshoot before reverting to trend.
Fourth, there were reports that the market selloff was exacerbated by the continuing unwinding of the Japanese carry trade. This trade involves borrowing in yen to purchase higher-yielding assets outside of Japan, and then selling those assets and paying off the yen debt. Once the Bank of Japan (BOJ) signaled the start of a significant tightening of monetary policy, the yen started to rise in value, thereby reducing the incentive to engage in the carry trade. Moreover, some nervous investors have been unwinding their carry trade positions, thereby putting upward pressure on the yen and downward pressure on the value of non-Japanese assets. Plus, the sharp rise in the yen has spooked holders of Japanese equities. In fact, Japanese equities fell 12% on August 5, the biggest decline since 1987.
Fifth, the selloff involved a very sharp decline in the prices of several key technology company stocks, especially those heavily investing in gen AI. One could argue that the tech bubble has burst following an unusually strong rise in the values of these stock. Yet the bursting of a bubble does not necessarily imply an imminent recession.
Sixth, the selloff may reflect fear that the US Federal Reserve waited too long to start cutting interest rates, thereby boosting the likelihood of a recession. Yet the futures markets now tell us that investors are expecting aggressive action by the Fed. In fact, they are pricing in a 25% probability that the Fed will take emergency action before the September meeting. And they are pricing in 125 basis points of interest-rate cuts before the end of the year. Such an aggressive action would likely lead to a sharp rebound in asset prices. It would also set the stage for a sharp increase in transactions. In fact, it’s reported that leading private equity (PE) firms have significantly increased the amount of funds deployed. Plus, they are sitting on a vast pool of “dry powder” that they intend to deploy as interest rates start to come down. Thus, there’s reason to expect a surge in M&A activity following the recent hiatus. As the head of one large PE firm said, “The deal market is back.”
None of this is to say that a recession is impossible. Rather, the point is that the rout in asset prices in the week of August 5 was not necessarily a predictor of a downturn. It could simply be a correction involving an intensification of volatility.
Indeed, US and Japanese equity prices rebounded sharply last Tuesday and markets were more stable for the remainder of the week. US traders were likely relieved that initial claims for unemployment insurance declined sharply in the week ending August 3. This suggests the possibility that the US job market is not so bad after all. Japanese traders were likely relieved that the BOJ signaled concern about the unwinding of the carry trade and appeared willing to take that into account in its deliberations about interest rates. Meanwhile, bond yields recovered, oil prices were up, and the US dollar recovered against the British pound and the Japanese yen.
Does this mean that the worst is behind us? Although market corrections happen periodically, they always seem to unnerve everyone, leading to concerns that something awful is about to happen. In this case, expectations for a US recession increased suddenly, even though underlying factors suggest otherwise.
In any event, measures of volatility have eased substantially, asset prices have mostly recovered, as least partly, and the economic fundamentals have not changed. Thus, it seems safe to say that the crisis is over, or at least the perception of a crisis. After all, there was not really a crisis.