A lot has happened in global markets over the last couple of weeks, causing much confusion and uncertainty among investors. A handful of crucial contributors triggered this market sell-off, which was then exacerbated by a few additional elements, all culminating in the fastest downturn for global risk assets since COVID-19.
Economic Warning Signs
Outside of inflation, there are two key ways that markets gauge the health of an economy: those being growth and employment. A couple of weeks ago we saw indicators for each of those reach concerning thresholds. These indicators are highlighting concerns about the economy and elevating the short-term risks of owning stocks and crypto.
Warning 1: The Sahm Rule
This indicator gauges labor market conditions to signal the early stages of a recession. When the three-month moving average of the national unemployment rate rises by 0.5 percentage points or more relative to its lowest point in the previous 12 months, it signals a recession. Going back to 1960, it hasn’t missed yet, and recently it just hit 0.53, breaching the threshold.
Warning 2: The ISM Manufacturing PMI
The ISM Index gauges activity in the manufacturing side of the economy across multiple datapoints, including employment, prices paid for goods, and purchases (aka demand).
Its latest reading, which just came in Thursday morning, surprised to the downside and is back at the levels it was in June and November 2023. Its current trend over the last 4 months has been negative, with 4 consecutive surprises to the downside each time.
These indicators have created much fear and uncertainty regarding the risks in the U.S. and global economy, which has triggered falling yields and increasing expectations of a Fed rate cut.
At the same time, on the opposite side of the world, the Japanese central bank just raised interest rates from 0.1% to 0.5%, leading to strength in the Japanese yen. This is another negative factor for Japanese stocks on top of the U.S. and global growth scare.
To think about it very simply: slowing growth is negative for stocks, and rising interest rates are also negative for stocks. Stack these two influences on top of each other, and you get an accelerated sell-off.
The Market Reactions
Now that we have the basic macro aspects of this situation down, we can examine how markets reacted and what caused such a rapid sell-off from a more technical standpoint.
The Yen Carry Trade Unwind
For years, the Japanese yen has had almost 0% interest rates. So what investors have been doing is borrowing in yen to take advantage of the very low rates and then going to buy U.S. dollar-denominated assets.
But the Bank of Japan just raised interest rates from essentially 0% to 0.5%, while at the same time the U.S. bond markets are pricing in lower interest rates.
So what you’re seeing is decreasing U.S. rates and increasing Japanese rates, which decreases the spread of the carry trade and, more importantly, causes the dollar to fall relative to the yen, which you can see in the chart below.
Both of these factors have forced investors to unwind some of the trade, which essentially means they have to sell off risk assets in U.S. markets. And typically, when risk increases and stocks sell off, crypto falls harder.
The factor that had a more brutal effect on the Japanese market was the sudden strengthening of the yen. It’s commonly understood, that when a currency’s yields rise, the currency strengthens, which causes weakening of assets denominated in that currency. So in line with expectations, the sudden strengthening of the yen led to an accelerated sell-off in Japanese stocks, which fell over 12% in a single day—the largest single-day loss since the crash of 1987.
The Short Volatility Trade Unwind
The factor that exacerbated the U.S. market sell-off is the popular ‘short volatility’ trade, which has gained much popularity in the last 10 months or so.
To summarize this in as simple terms as possible: the S&P 500 Volatility Index (VIX) is a measure of the S&P 500’s implied volatility. Implied volatility basically tracks how much it costs to buy insurance on your portfolio via options. When uncertainty and fear in the market increase, the demand for options (insurance) also increases, and thus the price of options goes up.
When markets are stable and volatility is low, investors try to profit by shorting VIX futures or selling options. This trade also suppresses volatility because as more and more people sell options and short VIX futures, it keeps volatility down. This creates a ‘ball underwater’ effect: once you let go, the ball shoots up. And as we expected, that’s exactly what happened.
As you can see, the VIX hit its third-highest point ever. The only times it has been higher were during the 2008 financial crisis and the COVID-19 crash.
What’s Next for Markets
With all of the fear and uncertainty in the market and economy today, the big question is: what direction do we go from here?
Before we can determine where we’re going next, we need to first understand where we are. As we know, economic growth, employment, and risk assets are all highly correlated. This is because they’re all mostly driven by two key factors: financial conditions and liquidity.
To gauge where we are, let’s take a look at two charts. The first chart we’ll look at shows the Chicago Fed Financial Conditions Index and the z-score of Global Liquidity.
What you will see is that after bottoming out in late 2022, liquidity and financial conditions recovered for much of 2023. However, due to concerns about sticky inflation, the recovery has stagnated in the first half of 2024. This brings us to the second chart, which shows U.S. Net Liquidity and the U.S. Dollar Strength Index inverted.
In this chart, you’ll see that U.S. liquidity has been falling, which, along with high rates, has contributed to strength in the U.S. dollar. This is a key point to note because a strong dollar forces other countries into a position where they can’t lower rates and stimulate their economies because it will hurt their currencies too much.
This is why we’ve seen global liquidity stagnate, but the good news is that the global stagnation could be about to change. Why? Well, with U.S. inflation finally falling again and economic growth moderating, the U.S. Fed and Treasury will finally be able to shift to a more dovish monetary policy.
This, in turn, will lead to lower rates and a weaker dollar, which will mean that other countries, such as China in particular, will finally be able to stimulate their economies, facilitating a continuation of the global improvements in liquidity and financial conditions.
Our Outlook
In the short term, there is much more risk and uncertainty in the market as we are currently going through a macro transition phase with a lot of moving parts. However, as explained above, our current belief is that over the longer term, this uncertainty in the economy and financial markets will just be a bump in the road on the way to looser financial conditions, lower rates, and expanding liquidity.
Simply put, the most likely scenario is that these short-term growing pains will result in positive outcomes over the next 12 to 14 months, leading to a recovery in global growth and higher asset prices.