A week can be a very long time in financial markets, particularly in August. After last Monday’s rout in global stocks, a semblance of calm has returned to trading desks.
The S&P 500 index, the United States benchmark that suffered its worst trading day in two years on August 5, has regained most of its losses, as has the FTSE 100 and the value of US government bonds.
The wild round trip in asset prices can’t be dismissed as just the exaggerated gyrations of light trading in the summer weeks. There are important lessons we can learn about the market meltdown for trading psychology, central bankers’ behaviours and the economy itself. Here are three of them.
The first is that not all “cast-iron” indicators of a recession work all of the time. This derives from one of the initial triggers for last week’s selling, which was the July jobs report for the US. This showed an unexpected rise in unemployment and lower-than-expected jobs growth of 114,000.
The soft labour market figures were not wildly out of consensus but set off sudden fears about the world’s largest economy having fallen into a recession. That’s because the Sahm Rule — a traditionally sure-fire way to measure a downturn in the US — had been triggered. The rule states that the economy is already in a recession when there is an increase in the average three-month measure of unemployment of at least 0.5 percentage points compared with the low recorded over the past year. The US unemployment rate jumped from 4.1 per cent to 4.3 per cent in July, marking a 0.49 percentage point climb on Sahm’s measure.
The rule, named after Claudia Sahm, a former Federal Reserve economist, has been met in the past 11 US recessions dating back to the 1950s — leading to understandable concern about the true health of the labour market. Looking at jobs is a good way to measure the impact of monetary policy and, ironically, the strength of the labour market had been one of the main drivers behind the “soft landing” theory of the US economy over the past year.
But traders jumped from a longstanding benign view of the US economy to hitting the panic button based on one data point. The unemployment figure is important, but in this case, the Sahm Rule didn’t meet the smell test and Sahm herself has said that her measure probably doesn’t apply in this case. There are a number of reasons why, including the surge in immigration over the past year that has driven up labour supply and the unemployment rate, and the fact that Americans are not suffering from mass layoffs — the most important variable in every past recession.
The Sahm Rule is also invalidated by developments in other parts of the economy, which suggest a slowdown in growth rather than a calamitous downturn. A measure of economic growth from the Atlanta Fed is running at 2.6 per cent in the third quarter. On Monday, Goldman Sachs said it expected output to rise by 2.5 per cent in the second quarter. These figures are not consistent with a recession. There are also scant signs of significant asset price bubbles or corporate balance sheet woes.
The second lesson of the past week is that it is the “safest” trades that have the potential to blow up and send tremors through the financial system. In this case, it was the mass unwinding of hundreds of billions of dollars of the “carry trade” made by hedge funds, who over the past two years have been borrowing cheaply in the Japanese yen to invest in higher-yielding assets, pocketing the difference.
The carry trade is as simple as it sounds and rests on interest rate differentials in different currency blocs. Since 2022, Japan has been a global outlier in the rush to monetary tightening by keeping its interest rates negative, while other central banks scrambled to slay inflation. But on July 31, the Bank of Japan lifted its interest rate for only the second time in 17 years to around 0.25 per cent and said it would begin dialling back its quantitative easing. The yen jumped to a seven-month high, forcing funds to rapidly unwind their positions, reversing about 75 per cent of all carry trades, according to JP Morgan. The pullback affected all kinds of assets that had been the beneficiary of the yen carry trade, including US government debt or high-performing stocks such as Nvidia.
The souring of this easy money bet has echoes of last year’s Silicon Valley Bank collapse, which was the result of the “safe” trade in US government bonds. In that case, SVB was the victim of an interest rate environment that created a maturity mismatch between its long-dated assets (bonds, with a falling value) compared with its very short-run liabilities (deposits, that were being withdrawn at record pace).
The final, and perhaps perennial, lesson of the past week is that central banks are expected to ride to the rescue of embattled traders. This was egregiously displayed by the Bank of Japan last week, which was forced by the markets to relent by saying that it would continue with its monetary easing policy “for the time being”. The yen began falling in an act of market “bullying” according to Mohamed El-Erian, former chief executive of Pimco.
This pernicious dance between financial markets and central banks, whose primary mandate is to deal with inflation rather than bail out traders, is nothing new. It was on show when the Bank of England had to stem a rout in long-dated bonds caused by Liz Truss’s mini-budget by buying more bonds — a policy in direct contradiction to its monetary policy goals.
There are also countless recent examples of market “tantrums” that have forced the Fed to retreat at the first sign of trouble. There are many strange elements about the global economic cycle, but falling back on central bankers’ largesse is not one of them.
Mehreen Khan is Economics Editor of The Times