Financial markets are suddenly pricing in a strong likelihood of 1.5 percentage points in Federal Reserve rate cuts by the end of the year. Just a week ago, markets saw a 0.2% chance of such an outcome. In short, markets have gone haywire almost overnight, prompted by five developments that together have triggered a massive liquidity squeeze, though one that will likely fade.
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Markets appeared to be in the grip of panic on Monday, with the S&P 500 opening down about 4%. Even more startling, the CBOE Volatility Index (VIX) spiked 165% to around 62, reflective of extreme fear.
Markets started to come unglued after Friday’s jobs report came in much weaker than expected, even though bad weather was an extenuating factor. However, investors gained some composure after two reports on U.S. service-sector activity in July showed a solid backdrop.
Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
Deutsche Bank strategist Jim Reid noted that the 20% dive in Japan’s Topix index was the worst three-day fall in its history. In the U.S., the 10-year Treasury yield dived 40 basis points last week, the biggest plunge since the peak of the financial crisis in 2008. The 10-year yield dived another 10 basis points early Monday.
“It’s safe to say they wouldn’t have been nearly as big if it wasn’t August,” when markets tend to be relatively illiquid, Reid wrote.
“All the moves are grounded in some reality though,” he added. The Bank of Japan is king “for the first time in two decades, tech has been at extreme levels of valuations and positioning, and payrolls on Friday were not good even if the market seems to have largely dismissed the obvious weather impact.”
Bank Of Japan Jolts Yen
First came the Bank of Japan’s hawkish policy surprise last Wednesday, announcing a rate increase in addition to tapering of bond purchases. BCA Research called the BoJ moves “the most hawkish signal on monetary policy we have seen in decades” out of Japan.
July Jobs Report Miss
With tighter monetary policy in Japan putting upward pressure on the yen, the impact of Friday’s big jobs-report miss was compounded. Recession fears have suddenly reemerged in the U.S., after just a few soft data points blew apart confidence in a steady growth outlook, or at least a soft landing. As of Friday’s close, markets saw strong odds of at least a full point in rate cuts, as the Fed works to save off recession.
Actually, the jobs report wasn’t that bad. The 114,000 employment gain badly trailed economists’ 180,000 forecast, while private-sector employers added just 97,000 jobs, far shy of 155,000 expectations. Yet the number of workers sidelined by bad weather jumped to 580,000 in July from 368,000 in June, suggesting that Hurricane Beryl may have accounted for the big miss.
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Yen Carry Trade Unwinds
Interest rates are rising in Japan and falling in the U.S., both to a surprising degree. That’s shifting the dynamics behind the yen carry trade, through which investors can borrow funds at Japan’s low rates and invest them abroad to net higher returns. That trade works great when the yen is flat or falling vs. the dollar, but not when it’s rising.
“Since 2023 (at least), speculators borrowed money in Japan at near-zero interest rates,” investment strategist Ed Yardeni wrote in a weekend note. “They converted their borrowed yen into dollars, and bought the Nasdaq 100. That drove the yen further down and the Nasdaq 100 further up.”
The carry trade began to gradually reverse in recent weeks, but began to crescendo on Friday, Yardeni says.
VIX Explodes
BCA strategist Peter Berezin wrote a Monday post pointing to another culprit behind the liquidity squeeze that has markets in turmoil.
“I know everyone is blaming the sell-off in stocks on the Yen carry trade, but the short vol (volatility) trade is probably the bigger culprit.”
The CBOE VIX index can offer a hedge against sudden market downturns. However, if investors are positioned for continued low volatility, as has been the case, the reversal can be even more jarring.
Iran Set To Retaliate
The U.S. and Israel are bracing for Iran to retaliate for Israel’s attack inside of Iran last week that killed a Hamas leader involved in cease-fire negotiations. Iran’s prior missile attack on Israel in April was fended off without resulting in tit-for-tat escalation.
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