Recession fears drive volatility

One of the biggest arguments against central banks has always been about whether it has been able to time monetary policy changes when necessary and not too late or too early. — Bloomberg

LAST week, this column analysed the global debt level and its implication on the economy and currencies, and about a month ago, another article with respect to the likelihood of the US Federal Reserve (Fed) cutting the key benchmark interest rates was presented on the back of weakening jobs data and tamed inflation prints.

The scenario painted then in the July 13, 2024 column was that the Fed is likely to cut rates by 50 basis points (bps) this year, and able to contain a hard-landing scenario.

Fast forward to this week, and the market turned topsy-turvy.

Having been following the markets for decades, one would always remember the yesteryear market’s turmoil brought about by a turn of events, mostly geopolitical risk, or in some instances, weak economic data points and, of course, the once-a-lifetime global pandemic.

The global stock market crash of October 1987, nicknamed “Black Monday”, brought fresh memories to this week’s market meltdown, while the manner and intensity of market volatility brought us back to the financial market mess, created by sub-prime mortgage lending in the United States, which was followed by the 2008/2009 global financial crisis.

Every asset class reacted to the weak US jobs report last week coupled with the weak Institute of Supply Management (ISM) Manufacturing Purchaser’s Managers Index indicator, which fell off the cliff, and came at just 46.8 for July 2024 versus forecast of 48.8, signalling a deeper contraction in manufacturing activities.

The United States equity markets reacted negatively to the above news and global markets tumbled.

In Asia, the Nikkei 225 was hit the most as the index fell by 12.4%, the second steepest fall ever, while other bourses saw steep declines.

Currencies too turned volatile as the yen surged to 143 to the US dollar while the ringgit rose to a high of 4.4 to the greenback.

After the initial shocking market moves on Monday, markets rebounded sharply the following days and regained some footing. Certainly, the past week’s market turmoil has taught us a lesson or two.

Blame Japan

As a sovereign nation, Japan has the right to set its monetary policy, and not be dictated by what the market demands or what the United States thinks Japan should do.

As mentioned before, Japan has the highest debt-to-gross domestic product (GDP) ratio among developed economies at more than 600% and much of this is sitting at debt taken by the financial sector as well as the Japanese government.

How this level of debt was allowed to grow to unprecedented levels has to do with the Bank of Japan’s (BoJ) monetary policy of leaving benchmark interest rates at not only a very low level but even negative. This allows complacency among borrowers as cheap money will fuel speculative activities, especially at a time when other developed economies were in a tightening mode, led by the Fed’s 525 bps increase in the Fed fund rate to the current 5.25% to 5.5% mark.

With near-zero rates, investors are able to generate alphas as they could even cover foreign exchange risk with the expected free money that they were going to make.

For the Japanese financial sector, raising cheap money and lending out at mediocre rates too had allowed them to generate positive net interest margins and increase their profitability.

In other words, a perfect win-win scenario for all.

Carry trades

For the longest time, borrowing in Japanese yen has provided investors with the best carry trades due to the lowest possible borrowing cost against the currency. This has allowed investors to leverage and trade not only in the United States market but also in other US-based asset classes like US Treasuries, commodities, and cryptocurrencies.

Additionally, they have been able to invest in higher-yielding assets, such as Australian sovereign papers or even those of emerging markets like Mexican and Indian papers.

The BoJ recently raised interest rates by 15 bps to 25 bps. With the weak US economic data points and worries that the BoJ may raise rates further and the possibility that the Fed may cut rates aggressively, massive unwinding of positions was triggered.

This caused the yen to rally sharply against the mighty US dollar. Foreign investors who have had equity exposure to the Japanese market too exited on fear that yen gains would trim their dollar-based portfolio gains.

This also caused the unwinding of other asset classes, including cryptocurrency’s, while currencies tied to the carry trade mania too weakened.

Bond yields

One of the most dominant gauges of incoming recession is the spread between the United States 10-year treasuries and the two-year papers.

Under normal circumstances, the longer end of the paper should trade at a higher yield when compared with the shorter end.

However, as the Fed began to aggressively raise rates, the shorter end began to reflect the market’s cost of funds, while on the longer end, yields jumped, but the increase was at a much slower pace.

The 10-year and two-year spreads inverted in July 2022, just before the Fed turned even more aggressive in raising rates, reaching 2.25% to 2.5% later that month.

The yield curve inversion has been accurate in predicting the past five recessions as it typically occurs between 12 and 18 months from the time the inversion is first observed.

Interestingly, by the time the National Bureau of Economic Research declares the start of the recession, this important recession indicator would uninvert and the entire yield curve would normalise.

Looking back, based on this gauge, recession in the United States has been imminent for a while now, and in fact, it has now been more than 24 months since the yield curve inverted but the US economy remains as robust as ever.

Only the recent weak jobs data and the US ISM Manufacturing gauge that was surprisingly lower than expected but the ISM Services index remained in positive territory, with a reading of 51.4 and ahead of market expectations of 51.0.

Recent US second-quarter 2024 GDP growth was robust with a quarter-on-quarter annualised growth of 2.8%, flatly beating the market forecast of a 2% expansion.

Interestingly, the GDPNow model suggests that the United States economy remains on track to achieve a growth of 2.9% this quarter. Certainly, the United States is nowhere near the recession level the market seems to be concerned about.

Fed wrong footed

One of the biggest arguments against central banks has always been about whether it has been able to time monetary policy changes when necessary and not too late or too early.

It needs to be ahead of economic data points as by the time these data points turn sour, it will likely be too late.

The Fed, which is dependent mostly on inflation and jobs data, has got it right for a while now, but it is likely to have been wrong-footed this time as both data are now pointing for the Fed to make a move – that is, to cut rates.

In addition, as these data are lagging indicators and a cut in rates does not have an impact on the real economy until about two quarters down the road, there seems to be a mismatch between what the data is telling us and what actions the Fed should be taking.

Some expected the Fed to make a surprise cut this week due to the market’s volatility, but that would be rather dumb, especially after last week’s Federal Open Market Committee meeting when the Fed took a view that it was open to cutting rates in the next meeting in September, as although inflation has eased, it remains elevated, while jobs numbers are more balanced as wage growth has moderated.

Of course, this was just two days before the July jobs number that showed the United States unemployment rate jumping to 4.3% from 4.1% while non-farm payrolls were weaker than expected.

For now, the market is pricing in that the Fed will cut rates by 100 bps in the next three meetings, with the likelihood of a 50 bps cut in the September meeting.

Interestingly, tracking the growth in the United States unemployment rate from the low to an increase of 0.9 percentage points (in the current scenario is the increase of the rate from 3.4% in April 2022 to 4.3% in July 2024), history has shown that past 12 recessions, dating back to 1948, started on average three months before this net increase was observed.

The shortest time frame that the US economy went into recession was within the same month itself while the longest was seven months before.

Hence, by this measurement, the United States is nowhere near being in recession. Even if the United States goes into a recession, it will likely be a mild one as the Fed is expected to step in to provide the necessary economic support and the market is well prepared for it.

Lessons learnt

In the financial markets, when there is an easy way to make money, it is a given that investors will take the opportunity to exploit the situation.

However, as carry trades have been around for a long time, there is no denying that it is difficult to control as these lending activities contribute little to the real economy but more towards speculative bets across the world.

We have seen this happen before during the 1997/1998 Asian financial crisis and with the extended balance sheet that the world has seen post-global financial crisis, cheap money has been fuelling asset prices for decades.

How do regulators control such behaviour unless there is a control mechanism that prohibits the usage of leverage to carry out speculative positions, be it short or long term? Otherwise, financial markets will never learn and history will repeat itself.

Pankaj C. Kumar is a long-time investment analyst. The views expressed here are the writer’s own.