Unwind

There are two sides of the leverage coin, excess returns and disaster. Even though the payoff for using leverage is asymmetrical, the allure of using it causes markets to do things like what it’s doing today and what it did at the end of last week. The basis for assuming risk is the confidence that an investor can always control it. The outsized profits that can accumulate only reinforce the belief that they will know when to get out before the music stops.

This move in stocks globally is a classic symptom of unwinding overly levered positions. A primary driver is the carry trade, which involves borrowing in almost zero interest yen-denominated loans and buying assets such as U.S. tech stocks on margin, among other things. With the Yen strengthening after the BoJ began to raise interest rates, this strategy started to get wobbly, and selling accelerated on Friday when the 10-year Treasury note broke below a 4% yield, and again overnight on reports of Buffett selling Apple.

To put this panic in perspective, the VIX peaked this morning at 65, which has happened only twice since 1990. In March 2020, at the depths of the pandemic, it took a week to find a bottom. In October 2008, at the selling climax of the Global Financial Crisis, it took two weeks. Markets opened with the fear of people scrambling to raise capital to meet margin calls and risk managers cutting the size of their institution’s positions to adjust for this heightened volatility. The one positive at midday is that the 2-year Treasury note yield is now back to Friday’s closing level, up a full 25 basis points from its low this morning, and the VIX is almost down to 50%.

Market Pushing Powell for the Put

Along with the Yen carry trade, the other driver responsible for this meltdown is the disappointment over the Federal Open Market Committee’s (FOMC) inaction on rate cuts. The ISM Manufacturing Employment subcomponent started the frustration on Thursday, just one day after the Fed held rates steady, and it intensified with Friday’s poor employment data. After that news broke, things got real: as risks to the labor market are finally rising, investors want the Fed to get in motion and cut rates. There is a market in FOMC emergency rate cuts (cutting rates before the next formal meeting in September), and investor impatience was evident this morning when it traded at over a 50% probability that the Fed would cut early. Chicago Fed president Goolsbee has been vocal both Friday and today. In response to a question about an emergency cut, he said: “Everything is always on the table.”

But then Goolsbee added that the “Fed can wait for more data before the September meeting...the July Jobs report is just one number.”

Goolsbee’s balancing act reveals that the Fed knows it will have to walk between the raindrops as it tries to contain investor concerns. We have a very light schedule for Fed speakers this week. At 5:00 p.m. E.S.T. today, be on the lookout for FOMC voter San Francisco Fed President Daly dropping any hints. Another voter, Barkin, president of the Richmond Fed, speaks Thursday. The less the Fed speaks, the better, because they could not possibly give the market what it wants, which is assurances it will go 50 basis points in September, or possibly earlier.

Glimmers of Hope in the Unemployment Picture

In Friday’s payroll report that added fuel to the selling, there were few positive factors. However, the rise in the participation rate of workers aged 25 to 64 was encouraging and is a key factor that the Fed monitors. Additionally, the Bureau of Labor and Statistics reported that over 400,000 nonagricultural workers could not work due to weather, versus a 30,000 average. Over a million full-time workers could only work part-time for weather-related reasons, versus an average of 200,000. Therefore, Hurricane Beryl did depress the data as a one-time event. On Monday, the Institute of Supply Management’s Non-Manufacturing Employment survey showed the first increase in 5 months, printing a 51.1 reading for August versus expectations of a 46 reading. The ISM Manufacturing Survey started this selloff on Thursday with a strong contraction in its Employment subcomponent, so the reversal in services was significant.

The improvement in the ISM Services employment data will probably keep the Fed stressing that last week’s July payroll could be an aberration. The blame for the market living and dying off the data point of the day lies with the Fed’s continuing message that they are data dependent. The fact that they are not being proactive has the market on edge that any one economic release can alter the direction of monetary policy. We are certainly witnessing the consequences of this reactive strategy with historically extreme volatility.

Watch the Upcoming Refunding for Clues

Tuesday through Thursday this week, we will see the 3-year note, the 10-year note, and the 30-year bond Treasury auctions, respectively. With yields trading so low due to a flight to safety from equity market turmoil, it will be interesting to gauge investor appetite for Treasuries. If demand is strong, then it will reveal that the market remains in risk-off mode. This morning’s yields hit levels not seen since June 2023, and at its current 3.80%yield matches the lows from December 2023, before selling pushed the yield over 4.70%. The equity market will be particularly sensitive to those results this week, selling off on oversubscribed auctions.

What to Look for This Week

1. The Federal Reserve’s Senior Bank Loan Officer Survey is out today at 2:00 p.m. Given the market’s new recession concern, any evidence of weak loan demand and tightening standards could depress market sentiment even further.

2. Global Supply Chain Pressure Index for June, Tues Aug 6, 10:00 a.m. from the New York Fed, which uses transportation cost data and manufacturing indicators to quantify global supply chain conditions changes that help forecast producer price inflation. It has remained below zero since March 2023, so if that continues in June, investors will feel the Fed will match their expectations for a 50 bp rate cut in September.

3. Initial Claims Thursday, August 8 at 8:30 a.m. E.S.T. After the unemployment scare, everyone’s focus will be on rising initial and continuing claims.