When Bad is No Longer Good
Economic data is neither good nor bad, but circumstances make it so. We’ve been living in a world where rapid U.S. economic growth was too fast, inflation too high, and the labor market too tight. The result was “higher for longer” when it came to the Federal Reserve and its interest rate policy. “Bad” economic data was needed. I put “bad” in quotes since none of it has really been bad, but rather weaker than recent history. And that has been a good thing since an economy that’s too hot has negative implications. The financial markets have been fine with this, and Goldilocks judged alive and well until she recently came down with the sniffles.
Rewind to July 11th and the last CPI release. For the third month in a row, the overall measures of headline and core inflation growth were lower than expectations.1 Within the details, hot spots were fewer and isolated mainly within shelter and health care… areas of well-understood structural, as opposed to cyclical, challenges.1 The “greater confidence” desired by the Fed when judging the lower path of inflation seemed to be building its case. The chart of the annualized 3-month moving average of CPI Headline, Core, and Sticky that we’ve been watching this year is shown below. It emphatically rolled over to new three-year lows with the June data. This was good news for inflation and the odds of a 0.25% Fed rate cut in both September and December increased.2 The S&P 500 continued higher.3
However, as second quarter earnings releases hit the news, companies were cautious with their outlooks and results that met expectations didn’t seem to make markets happy after weeks of new highs. The inflation data may have delivered on the interest rate front, but was the growth side of the equation now in danger?
Two employment reports were to follow. The Job Openings Labor Force Turnover Survey (JOLTS) on July 30th showed job openings, hiring, and separations were unchanged.4 This was more Goldilocks news. Then on August 2nd, the Employment Situation Report showed fewer jobs created than expected during July, a downwards revision to the June payroll number, and a tick higher in the unemployment rate to 4.3% from 4.1% the prior month.5 Momentum for Fed Funds interest rate cuts built again.2 But this time, fears over economic growth slowing too much weighed heavily on the calculus.
Across the Pacific in Japan, something else has been brewing. Since July 11th, the day after the CPI release, the Japanese Yen had been steadily gaining strength in global currency markets.3 Below is a chart of the Yen against the Dollar.
The Bank of Japan (BOJ) has been fighting its own inflation battle and recently raised interest rates to 0.25% from 0.0%-0.1% on July 31st.7 The BOJ has been at negative to zero interest rates since 2010.6 Juxtapose that against growing calls for U.S. Federal Reserve interest rate cuts after the Employment Report and you suddenly have the recipe for an accelerated, unexpected rise in the Yen that caused those participating in the Yen carry trade some major heartburn.
What is the Yen carry trade you ask? Suppose you are an international trader and you’re looking to borrow money cheap for speculative purposes. You would likely find the currency of a major trading economy with a near zero interest rate to be an attractive place to borrow. You borrow Yen expecting that your cost to borrow (interest rate) would remain low relative to the other major trading currencies (U.S. Dollar, Euro). With the proceeds of your cheap borrowing, you may reinvest in another currency and financial market instruments with expectations for higher for longer interest rates and a stock market concentrated in a few stocks with high confidence in meeting earnings expectations going into earnings season. In theory this works well, and indeed has worked for you this year. But then the interest rate on your cheap, borrowed, currency rises at the same time the interest rate on your long, invested currency is expected to fall. Add to that a news report on a Monday that one of your invested market’s darling stocks has a design flaw in its newest artificial intelligence chips,8 plus minutes from the Bank of Japan meeting suggesting it may want to raise interest rates further,7 and the unwinding of the Yen carry trade that was uncomfortable late last week turns downright ugly on a Monday morning. Those stuck in this trade must sell investments to cover their Yen borrowings while everything is going the wrong way.
The unwinding of a popular trade that has been trending for a period of time can produce sharp financial market movements. Short-term volatility is part of the landscape when it comes to investing. Markets will overshoot to the upside and the downside. Trying to time those movements is extremely difficult. It’s far better to focus on historical relationships between risk and return and how those work with your financial goals. We may be transitioning from a tight monetary environment to one that is less restrictive. Transitions take time and aren’t without surprises along the way as global financial market relationships change. Market action over the past several trading days is the result of forced selling among people needing to frantically cover positions that suddenly moved against them. Long-term investors don’t need to voluntarily include themselves in this situation. They have the luxury of not being forced to sell during times of heightened volatility. Take advantage of that. If the volatility makes you nervous, then it’s a great time to reconnect with your financial advisor and confirm that you’re on track.
Tracy Bell, CFA®
Chief Investment Officer
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1 Bureau of Labor Statistics at https://www.bls.gov/news.release/cpi.nr0.htm
2 CME FedWatch Tool at https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
3 FactSet
4 Bureau of Labor Statistics at https://www.bls.gov/news.release/jolts.nr0.htm
5 Bureau of Labor Statistics at https://www.bls.gov/news.release/empsit.nr0.htm
6 Trading Economics at https://tradingeconomics.com/japan/interest-rate
7 Reuters at https://www.reuters.com/markets/asia/some-boj-policymakers-warned-weak-yen-impact-household-mood-meeting-minutes-show-2024-08-05/#:~:text=ROUT%20CLOUDS%20RATE%20OUTLOOK&text=The%20yen%2C%20which%20hovered%20around,the%20July%2030%2D31%20meeting
8 Bloomberg at https://www.bloomberg.com/news/articles/2024-08-03/nvidia-s-new-ai-chip-delayed-due-to-design-flaws-information
Content should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgement of the author on the date of the publication and are subject to change. All investment strategies have the potential for profit or loss.
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