Markets Tank on Recession Fears

Welcome back to SovereignBeat!

In this publication:

• Biggest Selloff in 2 Years: Equity Indexes Dive Over 10% But Rebound by Week’s End

• Markets now see equal odds for one or two rate cuts in September amid recession fears

• Yen's rise forces massive unwinding of billions in carry trades

• Oil prices recover but stay $5 below pre-Gaza war levels

Let’s dissect

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Markets Snapshot

Macro and Fixed Income Markets

• US: Following disappointing job growth in July—where only 114K jobs were added versus the forecasted 175K—an unexpected rise in unemployment to 4.3%, slower wage growth, and a contraction in manufacturing activity as indicated by the recent ISM PMI, the market experienced a selloff on Monday and sharp volatility throughout the week, particularly affecting equities in the U.S and Asia.

• The relative calm on Friday came after data showed new US applications for unemployment aid—often used as an indicator of job cuts—fell to 233,000 for the week ending August 3, on a seasonally adjusted basis. This marked the lowest level in a month, falling short of economists’ forecast of 240,000, and was a decrease from the previous week’s revised figure of 250,000

• As concerns about a weakening labor market subsided, the yield on the 10-year Treasury fell 5 basis points to 3.94%. Additionally, a positive indicator of market liquidity was seen as assets in the Fed’s overnight reverse repo facility fell to their lowest point in over three years. This decline suggests that improved funding market conditions prompted financial institutions to move more cash away from the central bank.

• Markets dialed back bets on Fed interest rate cuts after the unemployment claims data, with the odds for a 50 basis points cut in September falling to 48% from 69% earlier in the week. Nonetheless, markets now roughly price in an equal probability for both 25 and 50 basis points cuts, a stark contrast to a few weeks ago when the prospect of two rate cuts in one meeting was largely off the table.

• Following a steep decline to near seven-month lows earlier in the week, the USD index (DXY) rebounded to 103.15. The U.S. Dollar Index is used to measure the value of the dollar against a basket of six foreign currencies: the Euro, Swiss franc, Japanese yen, Canadian dollar, British pound, and Swedish krona. This uptick indicates a decrease in market speculation about a potential emergency rate cut by the Fed, despite earlier recession fears. Goldman Sachs CEO David Solomon noted that the Fed is probably not going to take action before its September meeting, suggesting that the recent global market selloff might have been overblown.

• Japan: Investors continue facing severe disruptions from the unwinding of a popular strategy known as the carry trade, where money borrowed in Japanese yen is used to invest in higher-yielding assets elsewhere. This strategy was rattled as the yen strengthened for five consecutive weeks. The yen's recent appreciation has been partly attributed to the Bank of Japan's decision to raise its short-term policy target to 0.25%—the highest level in 15 years—up from the previous 0% to 0.1% range. Additionally, the Bank of Japan announced plans to taper its extensive asset-buying program, marking a significant shift from its decade-long stimulus strategy.

• The scale of the money involved in the carry trade is debated—ranging from tens of billions to potentially trillions of dollars—while JPMorgan Chase & Co. reports that three-quarters of the global carry trade has been unwound, erasing this year’s gains.

Equity Markets

• The major indexes rebounded from their largest sell-off in nearly two years by the end of the trading week. Friday’s gains boosted the S&P 500 by over 3.5% and the Nasdaq by more than 6.5% from the lows reached on Monday. To be more specific, the S&P 500 Index came close to correction territory, dropping as much as 9.71% from its peak in mid-January on Monday. Concurrently, the Nasdaq Composite had fallen 15.81% from its high, having entered correction territory the previous Friday.

• The CBOE Volatility Index (VIX), often referred to as Wall Street's fear gauge, experienced significant volatility, spiking to 65.73 on Monday—its highest level since late March 2020—before retreating to 20.69 by the end of the week

• European stocks advanced, with the Stoxx Europe 600 index rising by 0.6% to finish slightly above last week's closing level. France's Cac 40 increased by 0.3%, Germany's Dax was up 0.2%, and the UK's FTSE 100 gained 0.3%.

• Asian markets also saw a rebound, with Japan’s Topix climbing 1%, and both South Korea’s Kospi and Hong Kong’s Hang Seng rising by 1.2%. Japan has initially suffered the biggest decline during Monday’s sell-off, with the Topix plunging 12% in just one session. However, it rebounded the next day with its largest single-day gain since 2008 of more than 10%, as investors concluded that the previous drop had largely been a panic sell-off.

Our thoughts: Despite a rapid rebound this week in both equities and bonds, the August downturn of 2024 has made headlines, fueling discussions in the US presidential race and amplifying fears of a US recession or a misstep in monetary policy. In our view, the Fed could cut rates by 50 basis points in September without signaling a recession or suggesting that the situation is out of control. Markets have already partially priced in the risks of larger cut, and with inflation nearing 2%, the neutral policy rate should be lower than its current level. Our base case scenario continues to be a soft landing, which would also benefit many emerging market countries that we mention in this newsletter.

Commodity Markets

• Oil: Brent crude oil prices surged by 3.45% to around USD 79.50 per barrel from Monday, driven by better-than-expected US jobless claims and escalating Middle East tensions. Despite the rebound, prices are still $5 below their pre-war levels from October.

• Gold: The metal eased to about $2,420 per ounce on Friday after a nearly 2% gain the previous session. Similarly to other asset classes, after declining for five straight days through Wednesday, gold recovered most of its weekly losses with a surge in the last two days, driven by improved risk sentiment in the broader markets.

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