Markets have just suffered their biggest correction in 2024, with the S&P 500 falling over 9% from its peak and the tech heavy Nasdaq off over 13%. Asian markets sparked the equity route with an unwind in the Yen carry trade.
The Yen Carry Trade Unwind
The Yen carry trade is a financial strategy where investors borrow money in Japanese Yen (JPY) at very low interest rates and convert the money into another currency, and then invest in higher yielding assets such as bonds or equities. The goal is to profit from the difference between the low Japanese borrowing costs and the higher turns on investment elsewhere.
Problems occurred over the last few weeks when interest rates in Japan started rising, causing a subsequence strengthening in the Yen. This had a two-fold negative impact on the carry trade, the interest on investor loans goes up (bad), and the size of the loan in the foreign currency gets bigger (bad). Some people must therefore unwind the trade, by selling foreign assets (stocks and bonds) and repatriate Yen back to Japan. This has a knock-on effect of making foreign assets go down and the Yen more expensive. The more people who are forced to unwind the trade, the worse it gets for everyone else, and before long we saw a major route. By the end of yesterday’s session, the Nikkie was down 28% from its recent highs made only a few weeks ago.
This has caused a major setback in investor confidence around the globe. There are now a series of warnings signs lining up to indicate that the US recession has started.
Warning 1: When the Leaders Stop Leading
This year tech has been the leader with the AI revolution driving valuations for chip companies to dizzying heights. Nvidia briefly surprised Microsoft to become the world’s most valuable company with a market capitalisation of over $3.3 trillion dollars. The shine has started to come off the AI companies as the killer app to support these enormous valuations has yet to appear, while companies are haemorrhaging billions in hardware and compute costs to generate and run the AI models. This has led to speculation that the move in Nvidia might be repeating what happened to Cisco during the height of the tech bubble, in which Cisco become the most valuable company in the world in march 2000, and then declined by 88% over the following 2 years.
Warning 2: US Unemployment is Now on the Rise
US unemployment has been trending down for years to a multi-decade low and has recently starting to turn back up. Unemployment tends to trend in one direction for years, so when the trend changes from lower to higher, it’s time to pay attention. There is an indicator known as the Sahm rule which occurs when the unemployment rate increases by at least 0.5 percentage points from the low point over the preceding 12 months.
The Sahm rule has a perfect record of predicting recessions going back to 1960, and it has just triggered.
Source: Bloomberg, @KobeissiLetter via x.com
Warning 3: The Fed Is about to Go into a Cutting Cycle
The Fed is about to go into a cutting cycle. The chance of three rate cuts by the Fed by the end of 2024 has just soared from around 10% a week ago to over 94%. Although asset prices tend to perform better in lower interest rates environments, one must remember that recession usually starts after the Fed starts it’s cutting cycle. This was the case in 90/91, 00/01 and 07/08. It’s the reason that the Fed is cutting that is important, and is normally because the economy is slowing, unemployment is rising, and real rates have been moving higher.
Source: Convera, Macrobond
Warning 4: The Yield Curve Is Starting to Un-Invert
For those less familiar, this will occur when the short-term yield (eg 2-year) is lower than the longer-term yield (eg 10-year). The longest yield curve inversion in history (758 days) is close to ending today with the 10-year Treasury yield now only 0.08% lower than the 2-Year Treasury yield. Historically, the flip back to a positive sloping curve after a long inversion has occurred just before recession.
The question is, will this current selloff be just a blip in the road or develop into something deeper?
One thing for certain is that right now BOJ and other central banks will be working on a plan to stabilise markets if things continue to deteriorate. With the US election looming, now under 100 days, this is historically a bullish time for risk assets. Thus, the stage is also set for a market recovery. The biggest up days in markets generally follow the biggest down days. I do believe we will see continued pressure on the expensive AI sector, and perhaps some rotation from these AI names into more defensive and safe haven plays such as gold and short-term bonds. The latter two are likely to perform well, especially if central banks are forced into providing more stimulus. It’s also not a terrible time for investors to look at having more cash on the sidelines, to have liquidity if things go on sale again.
