Last week’s worries about a U.S. downturn accelerated Monday, and the global financial system went through a once-in-a-decade bout of volatility. Here’s what happened, and what to expect next…
By Phillip Patrick, for Birch Gold Group
Monday was a busy day at Birch Gold.
The labor market and inflation have cooled enough that Federal Reserve Chair Jerome Powell is openly contemplating cutting interest rates in September.
Investors would have been celebrating this news a month ago. But last week’s weak employment data, coupled with the unwinding of speculative trades that were profitable up to now, amplified concerns that Powell and other Fed policymakers waited too long to keep the economy from sputtering out. Now, they’re more worried that a recession is inevitable, regardless of the Fed’s actions.
These concerns, combined with a huge unwinding of a speculative currency trade, sent the CBOE Volatility Index or “fear gauge” to 65 at one point. That’s its greatest level since the early days of the pandemic panic four years ago. Currencies, crypto markets and certain commodities could remain volatile, analysts warned.
Monday was a bad day for millions of Americans. So what happened?
The latest economic reports simply don’t look good
It’s been less than two weeks since the latest inflation and unemployment data came out, “…yet there is growing sentiment that the Fed waited too long to cut interest rates and is now behind the curve,” John Lynch, chief investment officer for Comerica Wealth Management, said in an update. “While we’re not completely sold on the new narrative, the one thing that seems certain is that there is more volatility ahead.”
Last Friday, the Labor Department reported that the unemployment rate had risen more than expected. In other words, the economy is slowing and raising fears that the U.S. is unlikely to avoid recession after all. While that’s far from the story the Federal Reserve has been spreading over the last two years, it comes as no surprise to me.
The Friday report was even more important because the unemployment rate has risen enough to trigger a recession indicator, known as the Sahm rule, that has historically indicated we’re already in the early stages of recession.
What is the Sahm rule?
The most reliable economic indicator of recession, the Sahm rule measures real-time unemployment numbers against the three-month moving average. Here’s a longer explanation. Regardless, the Sahm rule was triggered, which indicates an official recession usually within one month.
Here at Birch Gold Group, we tend to take a long view. We understand that booms and busts, expansions and recessions, are just parts of the larger economic cycle. Ron Paul has an excellent column about this.
But to speculators, especially those trading the most economically-sensitive assets, the kind that rely on borrowing on margin for leverage to juice returns, a recession warning is a major concern. Furthermore, buying assets on margin is risky. Especially when prices fall. Investors who bought using credit are often forced to close their positions when prices fall more than expected, unless they have enough extra cash for collateral to deploy. And if investors don’t have extra cash, their brokers step in and liquidate their positions for them.
This “forced selling” is usually seen during times of high volatility, and puts downward pressure on asset prices. For the individual investor, it’s a disaster. More generally, it’s the kind of thing that makes an already bad day significantly worse.
Especially when a very popular strategy, like the dollar-yen carry trade, falls apart.
The dollar-yen carry trade unwinds
A carry trade is a kind of currency arbitrage. Hedge funds and institutional investors borrow money from economies with low interest rates such as Japan or Switzerland, to fund investments in higher-yielding assets in other countries.
Last week, Japan’s central bank raised interest rates and suggested that borrowing costs could go up further. The U.S. central bank, in contrast, signaled that it will likely cut rates soon as inflation fades, and the weak jobs report fed expectations that it might lower borrowing costs more quickly than expected.
That means Japan’s currency strengthened a lot relative to the U.S. dollar – squeezing investors such as hedge funds that had been borrowing cheaply in yen (that debt is now more expensive) and then investing in U.S. assets (those assets are now worth less). It’s sent them scrambling to raise cash, feeding the turmoil.
CoinTelegraph has a story about a crypto platform’s massive liquidations (and losses) as an example of this dynamic in action. The whole article is worth reading, but here are the highlights according to Mads Eberhardt, senior crypto analyst at Steno Research:
The most plausible reason, as I see it, is that Jump Trading has been borrowing yen to fund its high-frequency trading operations, perhaps to have enough liquidity at their disposal or to acquire crypto assets, in other words, as leveraged positions.
This may have led them to raise as much fiat as possible to pay back the loans. To do so, they must liquidate their most liquid bets, perhaps leading them to the fast liquidation of hundreds of millions worth of Ether.
I simply cannot find another explanation for why a respected trading firm, which should be well aware that crypto’s liquidity is extremely poor during the weekend, would still proceed to dump that much Ether in such a low liquidity environment.
This particular story has all the elements we’ve been discussing. And it’s just one example. This is the sort of thing that was happening all over the world on Monday.
What does this mean in the near-term?
A sudden global onset of risk-aversion should be taken as a sign. Wells Fargo Investment Institute President Darrell Cronk explained it like this:
We have clearly shifted the recent economic narrative from “bad news is good news” (assets rising in anticipation of more Fed rate cuts) to “bad news is bad news” (assets falling in reaction to concerns about weaker jobs market and recession/hard landing).
There aren’t many major economic indicators on the calendar between now and next week when the Labor Department will report the producer and consumer price indices for July. Furthermore, overall trading volume tends to be light during the summer – which means that volatility is higher.
Thanks to a phenomenon known as volatility clustering, periods of high volatility (large price movements) are usually followed by additional periods of high volatility.
In other words, right now is the time to consider risk reduction. According to Reuters, a lot of institutional investors are de-risking their portfolios. Should you do the same?
To be clear, markets can get disconnected from economic fundamentals. At the same time, markets can create new economic fundamentals, by undermining confidence. Forcing households and companies alike to reassess their budgets and change their plans for the future.