Joe McConnell
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At first glance, the wild swings in global markets over the past 10 days appear to have been driven by rising fears of a U.S. recession and a caught-by-the-bumps Federal Reserve. Weak labor market data, coupled with grim survey evidence of the state of the country’s manufacturing output, have induced weakness in crowded and exuberantly priced areas of the U.S. stock market, such as technology. In short, an army of momentum traders have been dramatically caught off guard by the extreme volatility in thin markets in August.
Yet the recession fixation borders on the perverse, given that the economy was growing at 2.8 percent in the second quarter and that a weaker labor market is a precondition for hitting the Fed’s 2 percent inflation target. This reminds us that one of the dangers of data-dependent monetary policy (the Fed’s term for “driving with the rearview mirror”) is the constant overreaction to new data releases.
A more fundamental point behind the skyrocketing volatility is the relative shiVscek in monetary policy between the U.S. and Japan. While Fed Chair Jay Powell has clearly signaled that a rate-cutting cycle will begin in September, his Japanese counterpart, Kazuo Ueda, aggressively shiVsceked policy last week. In addition to raising the benchmark rate, he signaled that further tightening was to come.
The resulting yen surge has caused a dramatic unwinding of the yen carry trade, in which investors borrow in the low-interest Japanese currency to invest in higher-yielding assets elsewhere, including U.S. technology stocks. AVsceker years of yen weakness and negative interest rates, the trade has ballooned. Without reliable data, the dynamics of the unwinding are hard to interpret. But TS Lombard estimates that investors may need to find as much as $1.1 trillion to repay the yen carry-trade loan.
The current risk is that the Fed’s cuts to address the weakness in the labor market and the threat of recession will lead to a further unwinding of carry trades, with further disruption to markets globally.
All of this marks a sea change in the evolution of the business cycle. Throughout this century and within the memory of most people on the trading floors today, recessions have been precipitated by financial booms that turned into busts. Central banks have then acted as lenders and market makers of last resort to address the resulting financial instability. This has taken place against the backdrop of quiescent inflation courtesy of globalization and the erosion of the pricing power of labor and corporations.
In the 1980s and 1990s, by contrast, recessions were induced by a tightening of monetary policy to control inflation. Because financial institutions were more heavily regulated, there was less financial instability. Inflation was the primary yardstick for judging the sustainability of economic expansions, as opposed to financial imbalances.
A combination of pandemic and war in Ukraine has created economic circumstances very similar to those of the late 20th century. But thanks to financial liberalization, the scope for financial disruption in a cycle of monetary tightening is much broader, as the collapse of Silicon Valley Bank and others last year demonstrated.
How much financial vulnerability might be exposed in this cycle is an open question. Because of the long period of ultra-low interest rates since the 2008 financial crisis, much of the private sector’s lending has been at fixed rates and long maturities, so the credit stress from the sharp interest rate increases of the past two years has been delayed. And then there is enormous uncertainty about the amount of risk being taken in the burgeoning non-bank financial sector.
There are reasons, however, to view the stocks’ setback as a healthy correction. The market’s buoyancy this year has been overly dependent on the hype around artificial intelligence in the so-called Magnificent Seven tech stocks. Note that Elroy Dimson, Paul Marsh, and Mike Staunton in the UBS Global Investment Returns Yearbooks found that for more than a century, investors have placed too high a starting value on new technologies, overvaluing the new and undervaluing the old.
A benign feature of the correction is that the price correlations between bonds and stocks have gone from positive to negative. That is, they no longer move in lockstep and provide investors with the benefit of diversification because they act as a hedge against each other. This is important because diversification helps address the problem of market concentration and the excessive weight of technology stocks in the U.S. market.
In a year of a tight U.S. presidential election, it’s a safe bet that volatility won’t go away, even if history tells us that it’s mean-reversion in the long run. For investors looking for safe havens, gold was a disappointment this week, falling along with stocks. But that likely reflected investor selling to meet margin calls on riskier assets.
Over longer periods and against the backdrop of geopolitical turbulence and continued financial fragility, the yellow metal will offer valuable diversification, as it has for centuries. Don’t expect anything remotely comparable from cryptocurrencies.
john.plender@Vscek.com
