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At first glance the wild gyrations in global markets over the past 10 days appear to have been driven by increased fears of US recession and of the Federal Reserve having been caught napping. Weak labour market data together with gloomy survey evidence on the state of the country’s manufacturing induced weakness in crowded and exuberantly valued areas of the US equity market such as tech. In short, an army of momentum traders was drastically wrongfooted by extreme volatility in thin August markets.
Yet the recession fixation borders on perversity given that the economy was growing at 2.8 per cent in the second quarter and that a weaker labour market is a precondition for the achievement of the Fed’s 2 per cent inflation target. That reminds us that one of the hazards of data-dependent monetary policy — Fed speak for steering by the rear-view mirror — is constant overreaction to new data releases.
A more fundamental point behind sky-high volatility is the relative monetary policy shift between the US and Japan. While Fed chair Jay Powell has clearly signalled that a rate-cutting cycle will begin in September, his Japanese opposite number, Kazuo Ueda, shifted policy aggressively last week. In addition to raising the policy rate, he indicated that there was more tightening to come.
The consequent rise in the yen caused a dramatic unwinding of the yen carry trade whereby investors borrow in the low-interest Japanese currency to invest in higher-yielding assets elsewhere, including US tech stocks. After years of yen weakness and negative interest rates this trade has ballooned. For want of good data the dynamics of the unwind are difficult to read. But TS Lombard estimates that investors may need to find up to $1.1tn to pay off yen carry-trade borrowing.
The risk now is that Fed cuts to address soft labour markets and the threat of recession will cause more carry trades to unwind, with further disruption in the markets globally.
This all marks a step change in the evolution of the business cycle. During this century and within the memory of most people on today’s trading floors, recessions have been precipitated by financial booms turning to busts. Central banks have then acted as lenders and market makers of last resort to address the resulting financial instability. Such action has taken place against the background of quiescent inflation courtesy of globalisation and the erosion of the pricing power of labour and companies.
In the 1980s and 1990s, by contrast, recessions were induced by a tightening of monetary policy to bring inflation under control. Because financial institutions were more heavily regulated there was less financial instability. Inflation was the chief yardstick for judging the sustainability of economic expansions, as opposed to financial imbalances.
A combination of the pandemic and the war in Ukraine has created economic circumstances very similar to the late 20th century. But thanks to financial liberalisation the scope for financial upsets in a monetary tightening cycle is much greater, as the collapse of Silicon Valley Bank and others showed last year.
How much more 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 private sector borrowing has been at fixed rates and long maturities, so credit stress from the sharp interest rate rises of the past two years has been delayed. And then there is huge uncertainty around the extent of risk taking in the burgeoning non-bank financial sector.
There are nonetheless grounds for regarding the setback in equities as a healthy correction. Market buoyancy this year has been overdependent on 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 have established that over more than a century investors have placed too high an initial value on new technologies, overvaluing the new and undervaluing the old.
A benign feature of the correction is that price correlations between bonds and equities 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 tech stocks in the US market.
In a knife-edge US presidential election year it is a safe bet that volatility will not go away, though history tells us that over the long run it is mean reverting. For investors looking for havens gold was a disappointment this week, falling alongside equities. But that was probably a reflection of investors selling to meet margin calls on riskier assets.
Over longer periods and against the background of geopolitical turbulence and continuing financial fragility the yellow metal will offer valuable diversification, as it has done over centuries. Do not expect anything remotely comparable from crypto.