Weekly Review - Swan Securities

Global markets have been particularly volatile in the past few days, with a global sell-off getting underway, due to many moving pieces contributing to the prevalent negative sentiment on the market. In our latest weekly update, we noted the increasing expectations for interest rate cuts from market participants and mentioned the 95.5% probability of a 25 bps rate cut at the September meeting from the FED and only 4.5% probability of no rate cut, based on the CME Fed watch tool. This week, the same tool seems to reflect a 0% probability of having no rate cut in September and an increasing probability of multiple rate cuts, with some participants putting forward the idea of a possible “inter-meeting” intervention from the FED. This drastic increase in expectation of policy easing came as market activity in the US took another turn in the past week following disappointing economic data released by the Institute for Supply Management (ISM) and the Bureau of Labor Statistics (BLS). As we mentioned previously, the ISM produces a leading indicator called the ISM Manufacturing index. This diffusion index suggests that manufacturing activity in a specific country is in expansion when the index is above to 50 points mark and in contraction when it is below the 50 points mark. Last Thursday the institute released its latest estimate of the manufacturing index for the US, which came in at 46.8 points in July, a drop from the previous reading of 48.5 points in June. Reaction was swift from the market as the S&P 500 fell 1.37% during that session. The index went on to lose another 1.84% during the following session on the back of the latest unemployment data released by the BLS showing that the metric reached 4.3% in July 2024, above the expected 4.1% by economists. The prevalent sentiment was bolstered by the jobs data released on Friday as the US economy added 114k jobs in July, less than the 12 months average of 215,000, which reinforced the market’s conviction of a softer jobs market and by extension increasing uncertainty regarding the US economic growth in the second half of 2024.

On the fixed income side, the 2 year US Treasury reached a new 52 week low on Monday as expectations of an impending rate cut strengthens among market participants. The yield on the 2 year US treasury dropped 47 basis points (Bps) between last Wednesday and last Friday’s close to reach 3.87%. Similarly, yield on the 10 year US treasury fell 37 bps over the same period to reach 3.789%, bringing the spread between the two tenure to a thin -0.08% as the yield curve may be nearing an un-inversion. The spread between the 10 year treasury yield and the 2 year treasury yield is often regarded as a reliable predictor of recessions in the US. When the spread turns negative, which is characteristic of a curve inversion, uncertainty regarding economic outlook tends to increase. Since the yield curve have been inverted for a significant period now, since 2022, it seems that it has taken a backseat in major medias. However, an important sign associated with inversions are the un-inversions. As a prelude to recessions, the yield curve generally un-inverts first as the short end of the curve drops to reflect upcoming rate cuts from the central bank. Readers will note however that while every recession were preceded by a yield curve inversion, not all yield curve inversions were followed by recessions. This key notion keeps dividing market participants to this day, with bulls and bears adjusting the narrative as it suits them.

With uncertainty being on the rise, the volatility index, the VIX reached an intra-day high of 65.73 points on Monday, a level not reached since the past two financial crises in 2020 and 2008. These levels of uncertainty compel some traders to close their positions as to minimize their losses, which adds up to the ongoing price pressures. Since the VIX is associated with uncertainty, by extension it is also a good way to gauge the current level of fear among market participants. However, is the fear really warranted at this point? Economic indicators such as the ISM Manufacturing Index and the Unemployment rate are volatile indicators. This means that according too much weight to one reading may not be appropriate. The Manufacturing PMI has been in contraction since October 2022, with a brief recovery above the 50 points marks in March 2024. Moreover, the drop witnessed in July 2024 remains less consequential than the drop seen in October 2023 when the PMI dropped from 49.0 points in September to reach 46.7 points.

Now taking a closer look at the unemployment rate released by the BLS, readers will note that the metric is calculated by dividing the number of unemployed individuals present in the labor force to the total labor force. This means that several factors could come into play and affect both the numerator and denominator and ultimately reflect on the unemployment rate. The institution reported last week that the number of unemployed people increased by 352,000 to reach 7.2m. Out of the additional unemployed people mentioned 249,000 came from temporary layoffs. On the other hand, permanent job losers only increased by 39,000, well below the 101,000 recorded in April 2024. The first comments made by a member of the FOMC came from Austan Goolsbee, Chicago Fed President on Monday. He explained that the jobs market did weaken but not to the point of looking like a recession. This seems to go against increasing market expectations of an inter-meeting rate cut between now and the September meeting. The latest data released from the ISM Services Index on Monday showed that Services PMI reached 51.4 points in July from a previous reading 48.8 in June. This does support the latest US GDP numbers for the second quarter of 2024 which displayed a resilient US economy.

Unfortunately, it would seem that for now the preservation instinct has taken control of the market, in these types of situation it is hard to tell when the market sell-off will end. We may yet see a recovery in the next few days, provided that the prevalent fear level among participants subsides. In the meantime, safe haven assets such as precious commodities will become particularly attractive for those wanting to earn a return while waiting on the sidelines. Those closing their positions to enter a wait and see mode are expected to increase in the coming sessions, especially given the mounting tensions in the middle east and Korea along with riots in the UK (amongst other events).

Another factor need to be taken into consideration regarding the intensity of the market sell off. Across the pacific, activity from the Bank of Japan is also pointed out as being a contributor to this market downturn. The Bank of Japan intervened last week to raise its key rate by 25 bps, which resulted in the strengthening of the Yen against other major currencies whose central banks are in the contrary inclined to cut rates. This contrast resulted in support for the Yen and downward pressure for other currencies. This resulted in an unsustainable environment using carry trade. As we explained previously, carry trade refers to the practice of raising cheap financing in a particular currency, in this case Japan and reinvesting the proceeds in other countries. The whole set up ideally requires FX rates to be relatively stable. This is why the Yen was a currency of choice for currency traders since the Bank of Japan was known for its inactivity in the past decade. The strengthening of the Yen is seen as another contributing factor to the market sell off as traders are forced out of their positions.